Managers' Overconfidence and Earnings Management through Classification Shifting: The Moderating Role of Managerial Ability

Document Type : Research Paper

Author

Associate Prof., Department of Accounting, Faculty of Economic and Social Sciences, Bu-Ali Sina University, Hamedan, Iran.

10.22059/acctgrev.2025.384305.1009036

Abstract

Objective
In recent years, accounting researchers have primarily focused on the management of discretionary accruals and the manipulation of real business activities, paying less attention to earnings management through classification shifting of income statement items. Although the topic of earnings management through classification shifting has recently gained attention from researchers, and some domestic studies have addressed it, there is limited empirical evidence on how classification shifting can be influenced by managerial beliefs. Therefore, this study aims to investigate the relationship between managers' overconfidence and classification shifting and examine the moderating role of managerial ability in this relationship.
Methods
To test the research hypotheses, data from 138 firms listed on the Tehran Stock Exchange over the period 2012–2023 (1,656 firm-years) were utilized. The Generalized Least Squares (GLS) method was applied for model estimation, with controls for both year and industry fixed effects. To address potential issues of heteroscedasticity and autocorrelation in the errors, cluster-robust standard errors at the firm level were employed. The models for measuring unexpected core earnings and unexpected changes in core earnings were estimated cross-sectionally at the industry level (120 industry-years).
 
 
Results
The research results indicate that a reduction in non-core earnings leads to an increase in unexpected core earnings and a decrease in unexpected changes in core earnings. These findings suggest the prevalence of the classification shifting phenomenon in Iranian firms. Additionally, the results show that managers' overconfidence strengthens the positive (negative) relationship between the reduction in non-core earnings and unexpected core earnings (unexpected changes in core earnings). With an increase in managerial ability, the impact of managers' overconfidence on the relationship between the reduction in non-core earnings and the two variables of unexpected core earnings and unexpected changes in core earnings diminishes. Furthermore, the results are not sensitive to the use of an alternative definition for measuring managers' overconfidence.
Conclusion
Based on the research results, it can be concluded that an increase in managers' overconfidence intensifies earnings management through classification shifting of income statement items. Overconfident managers have an exaggerated trust in their own abilities, and therefore, they intentionally classify some core expenses as non-core expenses to report higher core earnings than actual. This behavior not only skews the true financial performance of the firm but also misleads stakeholders relying on these statements. Furthermore, the research findings indicate that as managerial ability increases, the impact of managers' overconfidence on classification shifting diminishes. Compared to overconfident managers with weak managerial ability, overconfident managers with higher abilities have a more realistic assessment of their capabilities and sufficient capacity to meet their forecasts about the firm, thus having less motivation and need to reclassify income statement items. This suggests that improved managerial skills can mitigate the negative effects of overconfidence, ensuring more accurate and reliable financial reporting.

Keywords

Main Subjects

References

 
Abdoli, H. & Faraji, O. (2024). The impact of audit committee characteristics and audit fees on classification shifting of items in the income statement: Evidence from Iran. Financial Accounting Research, 15(4), 1-32. (in Persian)
Abernathy, J. L., Beyer, B. & Rapley, E. T. (2014). Earnings management constraints and classification shifting. Journal of Business Finance & Accounting, 41(5-6), 600-626.
Aflatooni, A. & Khatiri, M. (2024). COVID-19 and earnings management through classification shifting. Empirical Studies in Financial Accounting, 21(85). (In Persian)
Aflatooni, A., Arjmand, F. & Mahdigholi, M. (2023). Examining classification shifting behavior of earnings statement items: the effect of the CEO tenure. Financial Accounting, 15(58), 76-90. (in Persian)
Ahmed, A. S. & Duellman, S. (2013). Managerial overconfidence and accounting conservatism. Journal of Accounting Research, 51(1), 1-30.‏
Alfonso, E., Cheng, C. A. & Pan, S. (2015). Income classification shifting and mispricing of core earnings. Journal of Accounting, Auditing & Finance, 0148558X15571738.‏
Athanasakou, V. E., Strong, N. C. & Walker, M. (2009). Earnings management or forecast guidance to meet analyst expectations? Accounting and Business Research, 39(1), 3-35.‏
Athanasakou, V. E., Strong, N. C. & Walker, M. (2011). The market reward for achieving analyst earnings expectations: Does managing expectations or earnings matter? Journal of Business Finance & Accounting, 38(1‐2), 58-94.‏
Bansal, M., Kumar, A., Bhattacharyya, A. & Bashir, H. A. (2023). Predictors of revenue shifting and expense shifting: Evidence from an emerging economy. Journal of Contemporary Accounting & Economics, 19(1), 100339.‏
Barnea, A., Ronen, J. & Sadan, S. (1976). Classificatory smoothing of income with extraordinary items. The Accounting Review, 51(1), 110-122.‏
Barua, A., Lin, S. & Sbaraglia, A. M. (2010). Earnings management using discontinued operations. The Accounting Review, 85(5), 1485-1509.‏
Behn, B. K., Gotti, G., Herrmann, D. & Kang, T. (2013). Classification shifting in an international setting: Investor protection and financial analysts monitoring. Journal of International Accounting Research, 12(2), 27-50.‏
Biddle, G. C., Hilary, G. & Verdi, R. S. (2009). How does financial reporting quality relate to investment efficiency? Journal of Accounting and Economics, 48(2-3), 112-131.‏
Black, E. L., Christensen, T. E., Taylor Joo, T. & Schmardebeck, R. (2017). The relation between earnings management and non-GAAP reporting. Contemporary Accounting Research, 34(2), 750-782.‏
Blue, G. & Roosta, M. (2024). A model for managerial ability measurement with emphasis on accounting constructs. Accounting and Auditing Review, 31(3), 428-460. (in Persian)
Bradshaw, M. T. & Sloan, R. G. (2002). GAAP versus the street: An empirical assessment of two alternative definitions of earnings. Journal of Accounting Research, 40(1), 41-66.‏
Burgstahler, D. & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics, 24(1), 99-126.‏
Cain, C. A., Kolev, K. S. & McVay, S. (2020). Detecting opportunistic special items. Management Science, 66(5), 2099-2119.‏
Cheng, Q. & Warfield, T. D. (2005). Equity incentives and earnings management. The Accounting Review, 80(2), 441-476.‏
Choi, H., Gan, H. & Suh, S. (2024). Managerial overconfidence and classification shifting. Journal of Accounting and Public Policy, 43, 107176.‏
Cready, W., Lopez, T. J. & Sisneros, C. A. (2010). The persistence and market valuation of recurring nonrecurring items. The Accounting Review, 85(5), 1577-1615.‏
Demerjian, P., Lev, B. & McVay, S. (2012). Quantifying managerial ability: A new measure and validity tests. Management Science, 58(7), 1229-1248.‏
Fama, E. F. & MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81(3), 607-636.‏
Fan, Y. & Liu, X. (2017). Misclassifying core expenses as special items: Cost of goods sold or selling, general, and administrative expenses? Contemporary Accounting Research, 34(1), 400-426.‏
Fan, Y., Barua, A., Cready, W. M. & Thomas, W. B. (2010). Managing earnings using classification shifting: Evidence from quarterly special items. The Accounting Review, 85(4), 1303-1323.‏
Faulkender, M., Flannery, M. J., Hankins, K. W. & Smith, J. M. (2012). Cash flows and leverage adjustments. Journal of Financial Economics, 103(3), 632-646.‏
Financial Accounting Standards Board (FASB). (1984). Concepts Statement No. 5: Recognition and Measurement in Financial Statements of Business Enterprises. Norwalk, CT: FASB.
Francis, J., Huang, A. H., Rajgopal, S. & Zang, A. Y. (2008). CEO reputation and earnings quality. Contemporary Accounting Research, 25(1), 109-147.‏
Frankel, R., McVay, S. & Soliman, M. (2011). Non-GAAP earnings and board independence. Review of Accounting Studies, 16, 719-744.‏
Hamidian, M., Bozorgmehrian, Sh. & Janat Makan, H. (2018). The role of the auditor's expertise in the industry in preventing opportunistic reclassification of profit and loss statement items. The Financial Accounting and Auditing Research, 10(38), 93-113.
(in Persian)
Hashemi, S. A. & Rabiee, H. (2013). Analyzing earning management, using classification shifting operating to non-operating expenses at the middle fiscal periods. Accounting and Auditing Research, 5(18), 4-17. (in Persian)
Hastorf, A., Schneider, D., Polefka, J. (1970). Person Perception. Addison-Wesley, Reading, MA.
Haw, I. M., Ho, S. S. & Li, A. Y. (2011). Corporate governance and earnings management by classification shifting. Contemporary Accounting Research, 28(2), 517-553.‏
Hsieh, T. S., Bedard, J. C. & Johnstone, K. M. (2014). CEO overconfidence and earnings management during shifting regulatory regimes. Journal of Business Finance & Accounting, 41(9-10), 1243-1268.‏
Hwang, J., Choi, S., Choi, S. & Lee, Y. G. (2022). Corporate social responsibility and classification shifting. Journal of Accounting and Public Policy, 41(2), 106918.‏
Imeni, M. & Moshashaei, S. M. (2022). Investigating the effect of constraints on earnings management strategies on the application of earnings classification shifting strategy. Empirical Studies in Financial Accounting, 19(75), 203-236. (in Persian)
Imeni, M., Fallah, M. & Edalatpanah, S. A. (2021). The effect of managerial ability on earnings classification shifting and agency cost of Iranian listed companies. Discrete Dynamics in Nature and Society, 2021(1), 5565605.‏
Jones, D. A. & Smith, K. J. (2011). Comparing the value relevance, predictive value, and persistence of other comprehensive income and special items. The Accounting Review, 86(6), 2047-2073.‏
Jones, M. J. (2011). Creative Accounting, Fraud and International Accounting Scandals. John Wiley & Sons.‏
Kaplan, S. N., Sørensen, M. & Zakolyukina, A. A. (2022). What is CEO overconfidence? Evidence from executive assessments. Journal of Financial Economics, 145(2), 409-425.‏
Kasznik, R. & McNichols, M. F. (2002). Does meeting earnings expectations matter? Evidence from analyst forecast revisions and share prices. Journal of Accounting Research, 40(3), 727-759.‏
Kothari, S. P., Leone, A. J. & Wasley, C. E. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39(1), 163-197.
Kruger, J. & Dunning, D. (1999). Unskilled and unaware of it: how difficulties in recognizing one's own incompetence lead to inflated self-assessments. Journal of Personality and Social Psychology, 77(6), 1121.‏
Liu, X., Yang, J., Di, R. & Li, M. (2022). CFO tenure and classification shifting: evidence from China. Emerging Markets Finance and Trade, 58(6), 1578-1589.‏
McVay, S. E. (2006). Earnings management using classification shifting: An examination of core earnings and special items. The Accounting Review, 81(3), 501-531.
Pierk, J. (2021). Big baths and CEO overconfidence. Accounting and Business Research, 51(2), 185-205.‏
Presley, T. J. & Abbott, L. J. (2013). AIA submission: CEO overconfidence and the incidence of financial restatement. Advances in Accounting, 29(1), 74-84.‏
Riedl, E. J. & Srinivasan, S. (2010). Signaling firm performance through financial statement presentation: An analysis using special items. Contemporary Accounting Research, 27(1), 289-332.‏
Roychowdhury, S. (2006). Earnings management through real activities manipulation. Journal of Accounting and Economics, 42(3), 335-370.
Saghafi, A. & Jamalian Pour, M. (2018). Classification shifting phenomenon in earning management. Empirical Studies in Financial Accounting, 15(57), 1-23. (in Persian)
Schrand, C. M. & Zechman, S. L. (2012). Executive overconfidence and the slippery slope to financial misreporting. Journal of Accounting and Economics, 53(1-2), 311-329.‏
Watts, R. L. & Zimmerman, J. L. (1978). Towards a positive theory of the determination of accounting standards. The Accounting Review, 112-134.‏
Zalata, A. & Roberts, C. (2016). Internal corporate governance and classification shifting practices: An analysis of UK corporate behavior. Journal of Accounting, Auditing & Finance, 31(1), 51-78.‏
Zang, A. Y. (2012). Evidence on the trade-off between real activities manipulation and accrual-based earnings management. The Accounting Review, 87(2), 675-703.‏
Accounting and Auditing Review
Volume 32, Issue 2
2025
Pages 284-309

Files

Share

How to cite

Statistics