Management of Core Earnings Using Classification Shifting Around Seasoned Equity Offerings

34 Pages Posted: 16 Sep 2011 Last revised: 11 Feb 2013

See all articles by David T.L. Siu

David T.L. Siu

affiliation not provided to SSRN

Robert W. Faff

University of Queensland

Date Written: Feb 7, 2013

Abstract

McVay (2006) shows that managers can raise reported core (pro-forma) earnings by shifting core expenses to special items. While the bulk of the literature (e.g. Teoh, Welch, and Wong, 1998; Cohen and Zarowin, 2010) has exclusively focused on accrual- and real activities-based earnings manipulation methods, we provide the first known evidence of the manipulation of core earnings in the equity issuance context. To the extent that investors focus solely on non-GAAP 'core' earnings, managers have incentive to inflate core earnings rather than bottom-line return on assets (which remains unaffected) through accrual-based earnings management. If successful, this leads to investors misinterpreting the issue prospects and subsequently overvaluing new issues. Using a core earnings expectations model, which builds on the approach of McVay (2006) and extended by Fan, Barua, Cready, and Thomas (2010) with quarterly data, we provide evidence supportive of manipulation in the form of a positive association between income-decreasing special items and unexpected core earnings in the fourth quarter. We also find that issuers’ choices to use classification shifting or accrual earnings management strategies depends on auditor’ characteristics, flexibility and detection probability. Finally, we compare the effect of the two means of manipulation strategies and provide evidence that classification shifting is less likely than accruals management to be associated with post-issue performance declines.

Keywords: Classification Shifting, Special Items, Seasoned equity offerings

JEL Classification: G14, G32, M4, M41

Suggested Citation

Siu, David T.L. and Faff, Robert W., Management of Core Earnings Using Classification Shifting Around Seasoned Equity Offerings (Feb 7, 2013). Available at SSRN: https://ssrn.com/abstract=1928578 or http://dx.doi.org/10.2139/ssrn.1928578

David T.L. Siu (Contact Author)

affiliation not provided to SSRN

Robert W. Faff

University of Queensland ( email )

St Lucia
Brisbane, Queensland 4072
Australia

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