Auditors' Reactions to and Companies' Control of Classification Shifting

Abstract

Classification shifting is an earnings management tool that managers use to misclassify items within the income statement to inflate core earnings (McVay 2006). This study investigates how high-quality auditors (i.e., Big Four auditors, auditors with long tenure, and industry-specialist auditors) respond to managers' usage of classification shifting and also how the existence of internal control deficiencies affect the incidence of classification shifting. I adopt the models of Fan, Barua, Cready and Thomas (2010). My empirical analyses are based on quarterly financial data during the sample period of 1988-2007. I find that before the passage of the Sarbanes Oxley Act of 2002 (SOX), industry specialist auditors are able to curb the incidence of classification shifting. This is consistent with the findings of previous studies that high-quality auditors are capable of preventing managers from manipulating earnings. Furthermore, I document that before the passage of SOX, a high-quality auditor (i.e., a Big Four auditor) at a local audit office is likely to mitigate the classification shifting behavior of an economically important client. However, after the passage of SOX, a high-quality auditor (i.e., a Big Four auditor, an auditor with long tenure, or an industry-specialist auditor) is inclined to allow the classification shifting behavior if the client brings large revenues to the local office. This supports the "substitution effect", which suggests that companies replace the accrual-based management with the usage of other earnings management methods in the post-SOX period. Finally, I find that there is no relationship between the existence of material internal control weakness and the incidence of classification shifting. While there are ample studies about the reaction of high-quality auditors to the usage of accrual-based management and real activities management, my study provides empirical evidence about how high-quality auditors deal with the incidence of classification shifting. My study also provides an understanding about how an internal control system can influence managers' decision of choosing earnings management methods.