Purpose

This paper aims to examine whether financially distressed firms manipulate core or operating income through the misclassification of operating expenses as income-decreasing special items.

Design/methodology/approach

This sample comprises firms in the USA with data from 1989 to 2010. The authors used the methodology given in McVay (2006) and multiple regressions.

Findings

Managers of financially distressed firms are more likely to inflate core or operating income as compared to the healthy firms to meet or beat earnings benchmarks. They do so by misclassifying core or operating expenses as income-decreasing special items. Specifically, core expenses are shifted to income-decreasing special items like goodwill impairments, settlement costs, restructuring costs and write downs.

Practical implications

The paper sheds light on an important firm characteristic, financial distress that intensifies classification shifting – an earnings management tool which auditors, investors and regulators find tough to detect. The findings have implications for investors, as they fail to comprehend such shifting (McVay, 2006); analysts, who issue forecasts based on street earnings; lenders, as distressed firms may be concealing their true performance; and regulators, as the misclassification of income statement items is a violation of accounting principles.

Originality/value

The authors extend the literature on accruals and real earnings management by the financially troubled firms and present first evidence that the managers of such firms also manipulate core or operating income through classification shifting.