Negative Special Items and Future Earnings: Expense Transfer or Real Improvements?

Abstract

Burgstahler et al. (2002) evaluate special items, a component of earnings with time series properties that differ from recurring earnings, to determine whether the market correctly prices these transitory items. In addition, they investigate the implications of special items for future earnings and report evidence consistent with the notion that firms use negative special items to accelerate the recognition of future expenses into the current period. That is, negative special items serve as an “inter-period transfer” device. We examine additional predictions suggested by the inter-period transfer hypothesis. We find that earnings increase in post-special item quarters beyond the four quarters considered in Burgstahler et al. (2002). In addition, we find that the future earnings increases over the subsequent 16 quarters amount to over 130 percent of the negative special item reported in quarter t and over 40 percent of these increases are realized in operating cash flows. These earnings increases are greater for restructuring charges than for asset write-downs or goodwill impairment charges. Such patterns are more consistent with negative special items, and in particular restructuring charges, signaling real future performance improvements (i.e., performance improvement hypothesis) rather than inter-period expense transfer (i.e., inter-period transfer hypothesis).

Keywords: Negative special items, earnings management, Restructuring

JEL Classification: M40, M41