Fixing the Core, Earnings Management, and Sustainable Emergence From Financial Distress: Evidence From China’s Special Treatment System

Throughout their business life cycle, firms may experience financial distress. Successful emergence from such distress is important to their multiple stakeholders. Using a sample of publicly listed firms in China that emerged from Special Treatment (an indicator of delisting risk), we focus on the key actions such firms take prior to emergence, namely, fixing the core of the business and earnings management. We examine how these actions are associated with sustainable emergence, which we define as emergence from Special Treatment without reentry in the next 5 years. Consistent with the expectation that shortcut fixes to problems do not yield a long-term solution, we find that repairing the core of the business by improving operating efficiency is positively associated with sustainable emergence, whereas earnings management is negatively associated with it. We also find that the positive (negative) association between fixing the core (earnings management) and sustainable emergence is pronounced only for state-owned enterprises. Our article adds to the limited literature that examines issues related to distressed firms’ sustainable turnaround.

Debt financing and classification shifting of private firms

Purpose This study aims to examine whether debt financing creates incentives for private firms to engage in earnings management via classification shifting. Especially, the authors examine whether debt-induced financial reporting incentives differ depending on the type of debt (i.e. public bonds versus private loans) and whether such incentives are influenced by the characteristics of external auditors (i.e. initial audits and auditor size). Design/methodology/approach The study uses data on 93,427 Korean private firms from 2001 to 2016. Classification shifting is measured by the positive correlation between non-core expenses and unexpected core earnings estimated with ordinary least squares. Findings The empirical analyses reveal that private firms engage in classification shifting as do public firms. Importantly, classification shifting is observed only in private firms that have outstanding debt, but not in private firms without debt. Among debt-financing private firms, classification shifting is more prevalent for firms that issue public debt than for firms that only use private debt. In addition, classification shifting of debt-financing private firms is more successful when they are audited by new auditors that are one of the non-Big 4 firms. Research limitations/implications The study provides evidence of classification shifting in private firms, which is novel to the literature. However, the inferences in the study depend on the validity of the model for detecting classification shifting. Practical implications This study helps lenders enhance their understanding on the financial reporting behaviors of borrowing firms. The results in this study suggest that lenders should be cautious in using core earnings for their investment decisions. Originality/value This study contributes to the literature by providing novel evidence of classification shifting in private firms. In addition, the authors contribute to the literature on debt-induced incentives for financial reporting.

Non-GAAP Financial Measures: Evidence From Canada

This paper investigates non-GAAP financial measures voluntarily reported by Canadian companies listed on Toronto stock exchange (TSX) and Toronto Ventures Exchange (TSXV) for the year 2017. Non-GAAP measures are those that do not adhere to the requirements of generally accepted accounting principles (GAAP) and are used to communicate those aspects of firms’ operations which the firms see as relevant for the users of financial statements. This study is an exploratory research which describes current firm practices in reporting non-GAAP financial measures among three industry groups, namely Real Estate, Blockchain/Cryptocurrency and Cannabis firms. This paper also assesses the quality of non-GAAP financial disclosures in accordance with the regulatory guidance. The study is motivated by recent regulatory proposals issued by the Canadian Securities Administrators (CSA), under the National Instrument NI 52-112 and by the Accounting Standards Board (AcSB) pertaining to reporting non-GAAP performance measures. The main contribution of this study is a detailed content analysis of a sample of Canadian firms. My analysis of hand collected data from the Management Discussion and Analysis (MD&A) indicates a plethora of reported “non-GAAP financial measures” disclosed by companies. The analysis also indicates that firms are falling short on parameters such as understandability, comparability, standardization, consistency and persistence of non-GAAP financial measures which are essential under the existing guidelines, and that regulation of non-GAAP financial measures would be beneficial. The study’s findings may be relevant to regulators for formulating guidance on reporting non-GAAP measures and identifies areas of potential future studies in the area of non-GAAP financial measures. Keywords: Non-GAAP financial measures, Non-GAAP earnings, Pro forma earnings, Non-IFRS measures, Street earnings, Core earnings, Adjusted earnings and NI 52-112.

Non-GAAP Financial Measures: Evidence From Canada

This paper investigates non-GAAP financial measures voluntarily reported by Canadian companies listed on Toronto stock exchange (TSX) and Toronto Ventures Exchange (TSXV) for the year 2017. Non-GAAP measures are those that do not adhere to the requirements of generally accepted accounting principles (GAAP) and are used to communicate those aspects of firms’ operations which the firms see as relevant for the users of financial statements. This study is an exploratory research which describes current firm practices in reporting non-GAAP financial measures among three industry groups, namely Real Estate, Blockchain/Cryptocurrency and Cannabis firms. This paper also assesses the quality of non-GAAP financial disclosures in accordance with the regulatory guidance. The study is motivated by recent regulatory proposals issued by the Canadian Securities Administrators (CSA), under the National Instrument NI 52-112 and by the Accounting Standards Board (AcSB) pertaining to reporting non-GAAP performance measures. The main contribution of this study is a detailed content analysis of a sample of Canadian firms. My analysis of hand collected data from the Management Discussion and Analysis (MD&A) indicates a plethora of reported “non-GAAP financial measures” disclosed by companies. The analysis also indicates that firms are falling short on parameters such as understandability, comparability, standardization, consistency and persistence of non-GAAP financial measures which are essential under the existing guidelines, and that regulation of non-GAAP financial measures would be beneficial. The study’s findings may be relevant to regulators for formulating guidance on reporting non-GAAP measures and identifies areas of potential future studies in the area of non-GAAP financial measures. Keywords: Non-GAAP financial measures, Non-GAAP earnings, Pro forma earnings, Non-IFRS measures, Street earnings, Core earnings, Adjusted earnings and NI 52-112.

Do IPO Firms Misclassify Expenses? Implications for IPO Price Formation and Post-IPO Stock Performance

This study investigates whether initial public offering (IPO) firms inflate “core” earnings through classification shifting (i.e., misclassifying core expenses as income-decreasing special items) immediately prior to IPOs. We provide initial evidence that IPO firms engage in classification shifting in the pre-IPO period. Using hand-collected price and share information from IPO prospectuses, we find that pre-IPO classification shifting is positively associated with a price revision from the midpoint of the initial price range to the final offer price, suggesting that pre-IPO classification shifting influences IPO price formation. Furthermore, we find that pre-IPO classification shifting is negatively associated with post-IPO stock returns. Overall, our findings caution investors, auditors, and regulators that classification shifting, a seemingly innocuous accounting maneuver, can mislead investors in their IPO valuation and is associated with post-IPO underperformance. This paper was accepted by Brian Bushee, accounting.

Another Look at the Macroeconomic Information Content of Aggregate Earnings: Evidence from the Labor Market

We examine the macroeconomic information content of aggregate earnings from the labor market's perspective. We use insights from the labor economics literature to characterize the information contained in aggregate GAAP earnings and its components that is relevant for predicting aggregate job creation and destruction. Our results suggest that not only does aggregate earnings news convey information about future labor market aggregates, but its information content is incremental to other macroeconomic variables at near-term horizons. Further, the source of this information stems primarily from two earnings components: aggregate core earnings and special items. Shocks to core earnings signal persistent changes in economy-wide profitability that predict aggregate job creation up to four quarters ahead, while shocks to special items predict job destruction up to one quarter. Taken together, our results suggest that aggregate earnings contain useful information about future labor market conditions, with the nature of such information varying across earnings components.

Income Classification Shifting and Financial Analysts’ Forecasts

Income classification shifting involves misclassifying core expenses into non-core items to boost core earnings. Managers engage in classification shifting because they believe they can manage the perceptions of investors and financial analysts. We examine analysts’ earnings forecasts to determine whether analysts can identify classification shifting ex post and how they respond to shifted income statement components. Analysts play a role as information intermediaries between firms and investors. We find that analysts respond less to increased core earnings from classification shifting. However, analysts fail to gauge the full impact of classification shifting, leading to more optimistically biased and less accurate forecasts.