Earnings Management in India:

Managers’ Fixation on Operating Profits

Classification shifting in the income
statement
Particulars Amount

Sales

Cost of Goods Sold

Selling, General and Administrative Expenses

Depreciation

Core or Operating Income

Non-operating Income/Expenses

Income before Special Items

Special Items

Profit / (Loss) from Continuing Operations

2
 Classification shifting in the income
statement
• Dell shifted unrelated operating expenses to a
restructuring charge and used material
misreprentations during conference calls to
mislead investors and meet or exceed analyst
consensus forecasts
(AAER#3209, Alfonso et al. 2015)

• SafeNet improperly classified ordinary operating

expenses as non-recurring integration expenses
(AAER#3068, Alfonso et al. 2015)
3
Classification shifting in the income
statement
Particulars Amount

Sales

Cost of Goods Sold

Selling, General and Administrative Expenses

Depreciation

Core or Operating Income

Non-operating Income/Expenses

Income before Special Items

Special Items

Profit / (Loss) from Continuing Operations

4
 Research questions
• Do managers of Indian firms shift operating expenses
to income-decreasing special items in order to inflate
core earnings?
– Yes
• Do managers of Indian firms shift income-increasing
special items to operating expenses in order to inflate
core earnings?
– Yes
• Are managers of financially distressed firms in India
more likely to engage in classification shifting?
– Yes

5
Motivation and Hypotheses
 Significance of core earnings
• The value relevance of core/pro-forma
earnings is greater than that of GAAP earnings
(Wieland et al. 2013, Bradshaw and Sloan
2002)
• Exclusion of non-recurring special items by
analysts (Philbrick and Ricks 1991)
• Operating income is more persistent than non-
operating income and special items
(Fairfield et al. 1996)
7
 Classification shifting
• Managers shift operating expenses to income-
decreasing special items in order to inflate core
earnings
(McVay 2006, Fan et al. 2010)
• Classification shifting is used
– to avoid core losses or decline in core earnings
(Fan et al. 2010)
– achieving positive surprise to analysts’ forecasts
(McVay 2006, Fan et al. 2010, Athanasakou et al.
2011, Lin et al. 2006, Haw et al. 2011)
– prior to seasoned equity offerings (Siu and Faff 2013)

8
 Classification shifting
• Classification shifting is more likely to happen
– in the fourth quarter than in the first three quarters,
and
– when managers’ ability to engage in accruals
earnings management is limited due to prior
accrual manipulation (Fan et al. 2010)
• Classification shifting is less costly and tough
to detect (McVay 2006)

9
Corporate governance and institutional
environment in India
• Weak corporate governance and investor
protection (Narayanaswamy et al. 2012)
– Class-action lawsuits and lawsuits against the auditors
are uncommon
– Monetary penalties are miniscule and enforcement of
the laws is also weak
• Serious Fraud Investigation Office (SFIO) and the
case of Satyam Computer Services Limited
• Dominant role of family firms and presence of
controlling shareholders

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Corporate governance and institutional
environment in India
• Analysts do issue earnings forecasts in India
(DeFond and Hung 2003)
• Indian firms are more likely to manage
earnings by booking fictitious or advance
revenue (Gakhar 2014).
• Small firms and firms in the construction or
mining industries are more likely to manage
accruals in India (Ajit et al. 2013).

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 Hypothesis 1
• Classification shifting is used in the East Asian
countries (Haw et al. 2011)
– It is preferred over accruals manipulation
– Its use intensifies with the presence of controlling
shareholders
• Earnings management is more likely in countries
with weak legal enforcement and investor
protection (Leuz et al. 2003, Haw et al. 2004)

H1: Managers of firms in India shift core

expenses to income-decreasing special items
12
 Hypothesis 2
• IBM and Waste Management once used gain
on sale of assets to offset operating expenses
(Maremont and Bulkeley 2002, McVay 2006)

H2: Managers of firms in India shift income-

increasing special items to core expenses

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 Impact of financial distress
• Firms facing economic difficulties, having lower
sales growth, with poor profitability, and with
high leverage are more likely to report income-
decreasing special items
(Johnson et al. 2011, Elliot and Shaw 1988,
McVay 2006, Francis et al. 1996)
• Firms in decline sell assets to fund operations or
to repay debt (Dickinson 2011), and thus are also
more likely to report income-increasing special
items like gain on sale of assets
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 Impact of financial distress
• Firms with high debt-to-equity ratio are more
likely to disclose pro-forma earnings in their
press releases (Lougee and Marquardt 2004)
• Rewards for meeting or beating analysts’
forecasts are higher for financially distressed
firms as compared to financially sound firms
(Bartov et al. 2002)

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 Hypotheses 3 and 4
H3: Managers of financially distressed firms
in India are more likely to shift core expenses
to income-decreasing special items

H4: Managers of financially distressed firms

in India are more likely to shift income-
increasing special items to core expenses

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 Sample selection
• BSE listed Indian firms: 1996-2011
• Data source: Prowess
– Segregation of special items
• 14,386 firm years/1,514 firms
• Data winsorization at extreme 1%
• Sample comprises of bigger firms as compared
to population

17
 Research design
• McVay’s (2006) model

CEi,t = β0 + β1 CEi,t-1 + β2 ATOi,t + β3 TACC i,t-1 +

β4 TACCi,t + β5 CH_SALEi,t + β6 NEG_SALEi,t + ɛi,t

UE_CEi,t = α0 + α1 XEi,t

18
 Research design
• McVay’s (2006) model

CEi,t = β0 + β1 CEi,t-1 + β2 ATOi,t + β3 TACC i,t-1 +

β4 TACCi,t + β5 CH_SALEi,t + β6 NEG_SALEi,t + ɛi,t

UE_CEi,t = α0 + α1 XEi,t + α2 XIi,t

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 Research design
• McVay’s (2006) model

CEi,t = β0 + β1 CEi,t-1 + β2 ATOi,t + β3 TACC i,t-1

+ β4 TACCi,t + β5 CH_SALEi,t + β6 NEG_SALEi,t + ɛi,t

UE_CEi,t = α0 + α1 XEi,t + α2 XIi,t + α3 ZSCOREi,t-1

+ α4 BLOATi,t-1 + α5 BLOATi,t-1*XEi,t + α6 BLOATi,t-1*XIi,t
+ α7 ZSCOREi,t-1*XEi,t + α8 ZSCOREi,t-1*XIi,t
+ α9 BLOATi,t-1*ZSCOREi,t-1 + ɷi,t

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 Research design
• Altman's (1968, 2000) Z-Score
1.20*(Working capital/Total assets)
+ 1.40*(Retained earnings/Total assets)
+ 3.30*(Profit before interest and tax/Total
assets)
+ 0.60*(Market value of equity/Total
liabilities)
+ 1.00*(Sales/Total Assets)
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Results
 Financial Distress and Average Special Items
0.70

0.60 0.58

0.50

0.40
0.36
% of Net sales

0.30
0.25

0.20 0.18

0.10

0.00
0 1
Financial Distress

Income-decreasing special items (xe) Income-increasing special items (xi)

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 Financial Distress and Average Balance Sheet Bloat
500.00 474.64

450.00

400.00

350.00 329.37

300.00

% of Net sales 250.00

200.00

150.00

100.00

50.00

0.00
0 1
Financial Distress

Average Net Operating Assets (bloat)

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McVay's (2006) model fit statistics
Predicted Dependent Variable:
Sign cet

Intercept 0.143
(1.600)
cet-1 + 0.659***
(17.168)
atot - 0.029
(0.618)
tacc t-1 - -0.078
(-1.043)
tacct + -0.042**
(-2.324)
ch_salet + -0.411
(-0.862)
neg_salet + 1.377**
(1.992)
Adjusted R2 69.4%
No. of Industry-Years 421
No. of Observations 14386

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 Predicted Dependent Variable: ue_ce
Sign Panel A Panel B
xet + 1.875** 1.929**
Rs. 65 (150) lakhs
(2.285) (2.310)
xit - -1.489*** -1.464***
(-4.075) (-3.966) 0.11% (0.26%)
zscoret-1 ? 0.000 0.001 of Sales
(0.321) (0.436)
bloatt-1 ? 0.003*** 0.003***
(6.883) (6.364) 1.46% (3.38%)
bloatt-1*xet + -0.034*** -0.032*** of Core Earnings
(-5.360) (-5.098)
bloatt-1*xit - -0.008** -0.008**
(-2.526) (-2.535)
zscoret-1*xet + 0.319*** 0.324***
(3.805) (3.848)
zscoret-1*xit - -0.417*** -0.406***
(-6.697) (-6.498)
bloatt-1*zscoret-1 ? 0.000*** 0.000***
(6.730) (6.755)
Constant -0.006 0.016
(-0.639) (0.283)
Industry dummies No Yes
Year dummies No Yes
No. of observations 14386 14386
Adjusted R2 0.9% 0.9%
p-value 0.000 0.000 26
 Conclusion
• Managers of Indian firms do fixate on
operating profits
• Classification shifting seems to be widely
prevalent in India
• Its use is linked to financial distress
• Challenges before the Indian regulators and
auditors

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