Misclassifying Core Expenses as Special Items: Cost of Goods Sold or Selling, General, and Administrative Expenses?

50 Pages Posted: 20 Jul 2015 Last revised: 10 Apr 2017

See all articles by Yun Fan

Yun Fan

University of Oklahoma - Steed School of Accounting

Xiaotao Kelvin Liu

Northeastern University - Accounting Group

Date Written: June 23, 2015

Abstract

Prior classification shifting studies pool core expenses together and conclude that managers misclassify core expenses as income-decreasing special items to inflate reported core earnings (e.g., McVay 2006; Fan et al. 2010). Their core expense measure combines cost of goods sold (COGS) with selling, general and administrative expenses (SGA). This study models COGS and SGA separately and investigates the choice of COGS versus SGA misclassification that managers make to meet different profitability benchmarks. We find that when reported gross margin shows a small increase from four quarters ago, COGS (but not SGA) misclassification is more prominent. In comparison, both COGS and SGA misclassification are more prevalent when firms report small core earnings or small increases in core earnings and when actual earnings just meet or beat the analyst forecast in the fourth quarter. Moreover, our study sheds light on real activities management (RAM) research. Specifically, we find that managers engage in RAM of COGS to achieve the gross margin benchmark, but not core earnings benchmarks. For SGA, we show that unexpected SGA contain a significant expense misclassification effect, suggesting the importance to control for expense misclassification effect for future RAM research. Overall, our study extends prior expense management literature on both classification shifting and RAM.

Keywords: classification shifting; special items; gross margin; earnings benchmarks; real activities management

JEL Classification: M40, M41

Suggested Citation

Fan, Yun and Liu, Xiaotao Kelvin, Misclassifying Core Expenses as Special Items: Cost of Goods Sold or Selling, General, and Administrative Expenses? (June 23, 2015). Contemporary Accounting Research (2017) 34(1): 400-426., Northeastern U. D’Amore-McKim School of Business Research Paper No. 2633028, Available at SSRN: https://ssrn.com/abstract=2633028 or http://dx.doi.org/10.2139/ssrn.2633028

Yun Fan

University of Oklahoma - Steed School of Accounting ( email )

307 W Brooks
Norman, OK 73019
United States

Xiaotao Kelvin Liu (Contact Author)

Northeastern University - Accounting Group ( email )

404B Hayden Hall
360 Huntington Avenue
Boston, MA 02115
United States
617-373-5926 (Phone)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
270
Abstract Views
1,605
rank
134,634
PlumX Metrics