Do credit market incentives drive classification shifting in emerging markets?

Abstract

Purpose: To report inflated operating performance indicators, such as operating revenue and operating profit, managers vertically reposition revenue and expense items inside the income statement. This study aims to investigate the relationship between credit market incentives and these practices.

Design/methodology/approach: This study examined a sample of 1,592 Bombay Stock Exchange-listed companies from 2009 to 2021 and tested them using panel data regression models. The propensity score matching method and different measurements of classification shifting practices are used to validate the results.

Findings: The conclusions drawn from the empirical data show that firms prefer revenue shifting over expense shifting to prevent debt covenant violations. It shows that the firm’s classification-shifting practices are driven by credit market incentives. This finding is consistent with the notion of positive accounting theory that firms engage in classification shifting (earnings management) to avoid violation of debt covenants. Further, the firm’s preference for revenue shifting is in line with the ease-need-advantage-based shifting framework where firms choose the shifting tool based on costs and constraints associated with each tool.

Practical implications: The finding suggests that if managers heavily rely on revenue shifting to avoid debt covenant violations, the firm may end up breaking these covenants based on its actual operating performance. Managers may use aggressive accounting techniques to prevent covenant violations, which can be a warning indicator of financial difficulties or operational problems. It highlights the necessity for creditors and investors to carefully evaluate a company’s financial stability outside of the financial statements that are publicly disclosed. Authorities should create separate forensic accounting standards for auditors to check revenue items and stop the corporate misfeasance of revenue shifting.

Originality/value: The study is among the earlier attempts to provide empirical evidence on credit market incentives behind classification shifting practices. It is the first study that documents the substitution relationship between classification shifting forms for avoiding violation of debt covenants.