Elio Alfonso C.S. Agnes Cheng Shanshan Pan 2012

Definition of Core Earnings Core earnings are defined as operating income before depreciation and special items.

Examples of Income classification shifting On November 12, 2009, the SEC charged SafeNet, Inc. with the improper classification of ordinary operating expenses as non-recurring integration expenses (costs incurred to integrate acquired companies into current operations). The key issue of the income classification shifting is the persistence of the ‘over-stated’ core earnings after shifting will be lower than that before shifting.

In this example, in the Income Statement, Core Earnings are inflated by $5 due to classification shifting. The manager has shifted $5 from Operating Expenses to Special Items. Prior to shifting, Core Earnings was $55, Operating Expenses was -$15, and Special Items was -$2. Net Income of $21 remains unchanged as a result of shifting.

Objective To understand whether the market is able to effectively identify classification shifters and properly price them. To determine if the market is mispricing of core earnings for shifters versus non-shifters.

How to identify shifters from non shifters? Prior studies find a positive relation between unexpected core earnings and income-decreasing special items (McVay 2006) and income-decreasing discontinued operations (Barua et al. 2010). The measure of shifting, we categorize a firm as a classification shifter if the firm has positive unexpected core earnings and negative special items or negative discontinued operations in any given fiscal year.

Literature Review Sloan (1996) finds that investors seem to fixate on the persistence of earnings, failing to recognize the differential persistence of the accrual and cash flow components of earnings. According to McVay (2006), income classification shifting can have economically significant impact on security prices. Given the severe penalty by the market for firms that miss their earnings target by even one cent (Bartov et al. 2002), income classification shifting can substantially influence stock prices. H1: The core earnings of shifters are mispriced.

When core earnings are boosted, both the operating accruals and operating cash flows are also artificially increased, resulting in lower persistence of operating accruals and cash flows for shifters as well. If market does not see through the lower persistence of shifters’ operating accruals, it may overestimate its persistence to a greater degree for shifters. H2: The operating accruals and cash flows of shifters are mispriced to a greater degree than those of non-shifters.

Sample selection US firms over the period financial statement data are collected from Compustat and stock return data from The final sample includes 84,690 firm-year observations and 10,998 firms. Table

Models

With CE, core earnings, is defined as operating income before depreciation divided by average total assets9. ATO, asset turnover ratio, is sales divided by average net operating assets (NOA). NOA is operating assets minus operating liabilities. ACCRUALS is the prior year’s net income before extraordinary items minus cash flow operations divided by average total assets. ∆SALES is the percent change in sales over prior year sales. NEG_∆SALES is a dummy variable equal to 1 if ∆SALES is less than 0, and 0 otherwise.

Mishkin Test: Mishkin test, is used to examine whether investors correctly price core earnings for classification shifters relative to non-shifters.

Equation (3) is a forecasting equation that estimates the reported persistence (γ1) of core earnings. Equation (4) is a valuation equation that estimates the implied persistence (γ*1) that the market assigns to core earnings. If the implied persistence (γ*1) is less than the reported persistence (γ1) we assume that the market does not misprice core earnings (i.e. the market is not fixated on core earnings).

Authors expand the Mishkin test for the benchmark core earnings model by assessing whether the market rationally prices core earnings for firms identified as classification shifters by estimating the following system of equations:

With SHIFT is a dummy variable that is equal to one if a firm- year observation has positive unexpected core earnings as estimated from equation (1) and negative special items or negative discontinued operations, and zero otherwise. All other variables are defined as mentioned above. The

where Equation (11) is a forecasting equation that estimates the reported persistence (αi) of accruals and cash flows. Equation (12) is a valuation equation that estimates the implied persistence (α*i) that the market assigns to accruals and cash flows. EARN is net income divided by average total assets. NCE. ACC, accruals, is calculated as net income minus cash flow from operations scaled by average total assets. CFO is calculated as operating cash flow minus extraordinary items and discontinued operations scaled by average total assets.

Results Using the Mishkin test, we find that investors tend to overprice core earnings and accruals more for classification shifters than non-shifters. Therefore, authors conclude that investors overprice the core earnings and accruals of classification shifters and do not see through managers’ opportunistic strategy of shifting normal and recurring operating expenses to non- recurring categories.

Conclusion Investors overprice the core earnings and accruals of classification shifters and do not see through managers’ opportunistic strategy of shifting normal and recurring operating expenses to non-recurring categories.