Author(s): Kiwi Chung, Soojoon Chae
Classification shifting is an earnings management tool whereby managers shift operating income up the income statement by discretionarily classifying operating expenses as non-operating expenses. Since classification shifting does not change current-period net income, managers have an incentive to undertake shifting. Most previous studies have focused on earnings management methods in which managers adjust current-period net income. This study, therefore, examines the incentives to apply a different earnings management tool, that is, the arbitrary classification of expenses, in relation to audit quality sampling of companies listed on the South Korean stock market before the introduction of the International Financial Reporting Standards (IFRS). Starting in 2009, some South Korean companies adopted IFRS voluntarily, while all listed companies have been required to adopt IFRS since 2011. IFRS grants significant discretion to managers and thus, does not require the disclosure of operation earnings, making samples from the post-IFRS adoption period inapplicable to this investigation. This study, therefore, conducts a regression analysis on samples from 2002 to 2008. For audit quality, this study treats cases audited by any of the Big Four accounting firms as representative of a high-quality audit. When a Big Four auditor conducts an audit, managers are incentivized to opt for classification shifting as an alternative to an earnings management tool that increases current-period net income. However, an auditor providing a high-quality audit and properly fulfilling its role of monitoring the managers’ earnings management can decrease classification shifting. The empirical analysis reveals that companies audited by a Big Four auditor with high audit quality have a higher rate of classification shifting than other companies do. This outcome suggests that when audited by such a firm, managers are likely to choose classification shifting over an earnings management tool that adjusts current-period net income.