The use of special items to inflate core earnings.

Abstract

Investors place more weight on core earnings than transitory earnings. Consequently, the misclassification of expenses within the income statement, from core to transitory, offers a unique earnings management tool. This misclassification can influence investors' perceptions of firm performance and firm value. In this paper I document the shifting of operating expenses, such as cost of goods sold, to special items in the year the special item is reported. I find that approximately 7% of special items are not transitory, but rather are misclassified core operating expenses. This translates into $3.3 billion in shifted expenses for my sample of firms in the final year of my study alone. I find that managers shift more core operating expenses to special items preceding an equity issuance or when doing so allows the manager to meet the analyst forecast (which typically excludes special items). Finally, investors do not appear to fully disentangle expense-shifting. This action is associated with a negative abnormal return of more than 3% in the following year, suggesting investors are surprised by the recurrence of 'transitory' expenses.