A Comprehensive Analysis of the Use of Special Items to Manage Earnings

Abstract:     
We conduct a comprehensive analysis of the use of income-decreasing special items to manage earnings. In addition to correctly including unusual or infrequent charges in special items, managers can also misclassify future core expenses (e.g., future depreciation expense as an asset write-off), current core expenses (e.g., everyday severance fees as restructuring), or past core expenses (e.g., unrecognized bad debt expense as an asset write-off) as transitory. We model high- and low-quality special items and conclude that roughly one third of total special items would be better characterized as recurring expenses (i.e., are low-quality). We find that low-quality special items violate the concept of a transitory item, as they are associated with future operating cash flows, while high-quality special items are not, consistent with the theoretical concept of a transitory item (e.g., Ohlson 1999). Moreover, we document that low-quality special items predict accounting restatements, while high-quality special items do not.

Number of Pages in PDF File: 42

Keywords: Special items, earnings quality, earnings management, future operating cash flows, restatements

JEL Classification: M41, M43

working papers series