Classification shifting and the Big Four auditors
4 min read 27 Dec 2016, 12:31 AM ISTThe Big 4 auditors, because of their global operations, have incentives to develop and maintain strong and uniform reputations around the world
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Classification shifting typically involves misclassifying operating expenses as non-recurring expenses to inflate the core earnings of a company. For example, a recurring expense related to maintenance of manufacturing facilities could be treated as a one-time special item and be treated as non-recurring expense to inflate core earnings. Such misclassification of expenses does not affect the bottom line of the company; it only misrepresents the core earnings of a company. (McVay, in a 2006 article in The Accounting Review discusses the issue in detail.)
Classification shifting is a relatively low-cost tool for managing earnings as there are neither accrual reversals in the future, nor any lost revenues from forgone opportunities. Managers are motivated to misclassify earnings because the market participants focus more on core earnings rather than just the bottom line GAAP (generally accepted accounting principles) earnings which include certain non-recurring items. This is because market participants weigh different line items on an income statement differently and also because line items that are closer to sales (typically associated with core expenses) are considered to be more persistent than line items that are farther away from sales (typically associated with non-operating expenses).
Prior research indicates that while classification shifting does not affect the net income of a company, it significantly affects perceptions of persistence and growth associated with a company. For example, there have been instances where the market overvalues core earnings of companies that engage in classification shifting.
Additionally, companies are more likely to misclassify core expenses if such misclassification allows the company to meet or beat analysts’ forecasts related to core earnings, which in turn helps them avoid the negative consequences of missing such forecasts. The Securities and Exchange Commission (SEC) in the US has also realized that classification shifting could undermine the credibility of financial statements and adversely affect decisionmaking of various market players, and has been actively pursuing companies that indulge in classification shifting.
An important factor that could mitigate classification shifting is the quality of the company’s auditors. The auditors of a company are entrusted with the task of ensuring that the financial statements of a company are free of any material misstatements and that they present a true and fair view of the company’s financial position. Given the focus of the market participants on core earnings, misclassification of expenses could adversely affect the market participants’ ability to take informed decisions with respect to their dealings with a company. Prior research indicates that the Big 4 auditors are better than non-Big 4 auditors in preventing accruals-based earnings management.
However, this superiority of the Big 4 auditors in limiting earnings management that has been observed in the US context does not manifest itself in the Indian context, as shown by Joshy Jacob, Naman Desai & Sobhesh Agarwalla in 2015 (bit.ly/2hDZ0ix). Therefore, given the rising prevalence of classification shifting in comparison to accruals-based earnings management, we examined if the Big 4 auditors in India are relatively more likely to reduce classification shifting compared to non-Big 4 auditors.
The data for our study, which has been put out as an Indian Institute of Management-Ahmedabad (IIM-A) working paper, comprises firms listed in A and B groups on the BSE and for which the relevant data was available. The data was collected from the Prowess database which is maintained by the Centre for Monitoring Indian Economy (CMIE) and spans the financial years ended in March 1996 to March 2015. Our analysis was run on a sample with 23,605 firm-years. The results of our study indicate that the type of auditor (Big 4 versus non-Big 4) has a significant impact on classification shifting and that Big 4 auditors are significantly more likely to prevent classification shifting compared to non-Big 4 auditors. Our analysis of audit fees indicates that both Big 4 and non-Big 4 auditors charge higher fees to curb classification shifting.
However, this increase in audit fee is significantly higher for the Big 4 auditors than for the non-Big 4 auditors, thus, suggesting that Big 4 auditors do charge a higher fee compared to the non-Big 4 auditors, which leads to an improvement in the reported earnings in the form of reduced classification shifting.
India is supposed to have relatively strong legal institutions as it is a common law country. However, enforceability of laws in India is relatively lax; as a result the Big 4 auditors should be under less pressure to prevent earnings management. We argue that the Big 4 auditors, because of their global operations, have incentives to develop and maintain strong and uniform reputations around the world. Therefore, the Big 4 auditors would have more to lose than non-Big 4 auditors by allowing greater discretion in reported earnings either through accruals management or classification shifting.
As a result, even in a country with poor legal enforceability such as India, the Big 4 auditors would provide a superior quality of audit service as evidenced by reduced managerial discretion in the reported earnings.
Overall, the results indicate that the Big 4 auditors are aware of the increased prevalence of the classification shifting as a form of earnings management and are taking necessary steps to curb it.
Naman Desai, Joshy Jacob and Neerav Nagar are faculty members of the Finance and Accounting Area at IIM Ahmedabad.
