Earnings Management Using Classification Shifting:Influence Factors And Economic Consequences

Earnings management has long been one of the hot issues in the study of corporate finance.Previous studies mainly focused on accrual-based and real earnings management, but very few have noticed the management using classification shifting. Classification shifting is defined as a third tool to make earnings management, achieving the goal to overstate core profit by misclassifying items within income statement, for instance, shifting operating expenses to non-operating expenses or shifting non-operating revenues to operating revenues. Core profit plays a very key role in capital markets,directly affecting investors' and regulators' decision making. Earnings management using classification shifting does not reduce earnings in future,leading to a lower practice cost compared to the other two tools. Additionally, this tool is barely perceptible, for the net income does not change, thus limiting the scrutiny of auditors and regulators in practice. This paper begins with the analysis of specific methods of classification shifting adopted by Chinese listing companies and then discusses the influence factors and economic consequences of classification shifting. On the one hand, the paper presents the influence factors in the view of external governance by analyzing the impacts of two new policies implemented in recent years, i.e. securities margin trading and anti-corruption campaign, on the improvement of the quality of enterprise accounting information. On the other hand, from the perspective of investors and bank creditors, the paper points out two potential economic consequences caused by classification shifting: mispricing by investors and misallocation of resources in the credit market.The comprehensive study of classification shifting used by Chinese listing companies in earnings management help investors and regulators have a better understanding of corporate core profit. The study theoretically discusses the relationship between accounting items and the institutional background of accounting information disclosure. Combined with empirical methods,the author finds :(1) Chinese listing companies do employ means of classification shifting as a tool of earnings management. It is usually shown as the shift of non-operating revenues to operating revenues. However, in companies with low profit margin and companies that go public, managers would also shift expenses that should be classified as operating expenses to non-operating ones,suggesting classification shifting is more pervasive when managers have a stronger incentive to increase core profit. (2) Disclosing non-recurring gains and losses selectively is a special way of classification shifting used by Chinese listing companies. They are likely to disclose non-recurring gains as few as possible but fully disclose non-recurring losses. Therefore, the authenticity and credibility of the index "net income after non-recurring items" has yet to be improved. (3)Classification shifting of items within the cash flow statement is a supplementary way of earnings management, and the classification shifting of R&D can be regarded as a substitutionary method.Those companies using classification shifting would attempt to misclassify items within cash flow statement in order to overstate net cash flow from operations, mainly reflected as the shifting of cash outflow from operations to investing activities as well as the shifting of cash inflow from investing activities to operations. On the other hand, the misclassification of R&D is discovered in companies in the absence of classification shifting. Since R&D is another key indicator affecting stock prices in addition to core profit, these companies tend to classify operating expenses as R&D.Therefore, the existence of these two means of misclassification makes it even more difficult for people to judge the authenticity of core profit both in depth and width respectively.Unlike existing studies that primarily illustrate the influence factors of classification shifting from either corporate governance or corporate characteristics, this study tries to investigate how the earnings management tool by misclassification of item is affected by the introduction of short sales mechanism and the launch of anti-corruption campaign. In the application of multiple econometric methods, such as, panel data regression model, DID, logit model, placebo test, etc.,the author finds:(1) Short sales mechanism is effective in reducing the occurrence of classification shifting in listing companies, which implies that it is an important corporate governance mechanism. This effect is especially significant in companies lack of good corporate governance both internally and externally. Therefore, it can be inferred that short sales mechanism can make up for the deficiency of external governance environment as well as internal monitoring mechanism. (2) The anti-corruption campaign exerts an inhibitory effect on classification shifting in corporate earnings management and can be referred to as a brand new type of unofficial governance mechanism. This inhibitory effect is even greater in state-owned enterprises and companies in highly developed markets. The anti-corruption campaign affects classification shifting by reducing agency costs and improving business performance, and the former one is the major channel.Core profit is informative and is usually used by corporate stakeholders in decision making.This paper presents the economic consequences of classification shifting from the perspective of investors and creditors. The author analyzes investors' functional fixation behavior on profit information and investigates the relationship between credit decisions and accounting information,based on which, the author draws the following conclusions in the application of multiple methods,such as, panel data regression model, arbitrage test, etc. (1) It is hard for those companies that make earnings management using classification shifting to keep the growth of core profit in the long run. Since this tool is hard for investors in capital markets to identify, the investors might misprice core profit of these companies. To be more specific, the core profit is overstated. The mispricing can be mitigated to some extent when there is a relatively high proportion of institutional investors. (2) Companies obtain more long-term loans from banks through classification shifting, which implies that banks cannot fully identify the authenticity of corporate core profit in the procedure of credit approval. The extent of the misleading effect depends on the degree of corporate political connections and the level of regional financial marketization. The effect of credit misallocation is even more significant in politically connected companies and companies in low level of marketization. In the region where banks face severe competition, banks have a low requirement for the quality of corporate accounting information, thus further weakening the ability to identify classification shifting.