Investigate the Effect of Board Characteristics on the Relationship between Ownership Structure and Classification Shifting

Objective: Previous research on earnings management has focused mostly on accruals earnings management methods and real earnings management. Recently, a third tool called classification shifting for earnings management has been considered. Classification shifting occurs when management intentionally misclassifies parts of recurring operational expenses as income-decreasing special items (McVay, 2006). This can inflate core earnings; for example, by hiding parts of the recurring administrative expenses among none operational items. Income Shifting within the income statement does not change bottom-line income but does increase perceived core earnings, an alternative performance measure often emphasized by financial analysts and investors. results of previous studies like McVay (2006) provide evidence of higher levels of classification shifting when management has incentives to act opportunistically to meet or beat consensus analysts' earnings forecasts. Different studies (MacVay, 2006; Saghafi and Jamalian, 2018) documented evidence of using classification shifting as a method of earnings management by the managers in different markets. Some other studies report that a strong investor protection environment and strong internal corporate governance tend to mitigate classification shifting (Behn, Gotti, Herrmann, & Kang, 2013; Zlata & Roberts, 2016). Also, the role of ownership structure, which is argued to have a significant impact on earnings management, should not be neglected. The value of a strong board and audit committee arises, in part, because they constitute a form of monitoring, curbing opportunistic managerial behavior, and therefore reducing information risk (Zlata & Roberts, 2016). Although there is general agreement that strong boards and audit committees curb accrual-based earnings management. In addition, due to the importance of the supervisory role of the board of directors in the company and its impact on the efficiency of supervisory mechanisms in the present study, some characteristics of the board of directors like board size and proportion of independent directors are also considered. Therefore, this study aims to investigate the effect of board characteristics on the relationship between ownership structure and classification shifting. This study investigated the role of board size and independence in the relationship between ownership structure and classification shifting.
Method: The present sample of the present study includes 105 companies listed on the Tehran Stock Exchange from the period 2016 to 2020. In order to test the research hypotheses, multiple regression analyses have been used. Based on theoretical foundations these hypotheses were developed and tested:
H1: there is a relationship between intuitional ownership and classification shifting.
H2: there is a relationship between state ownership and classification shifting.
H3: board size has a significant effect on the strength of the relationship between intuitional ownership and classification shifting.
H4: proportion of independent directors has a significant effect on the strength of the relationship between intuitional ownership and classification shifting.
H5: board size has a significant effect on the strength of the relationship between state ownership and classification shifting.
H6: proportion of independent directors has a significant effect on the strength of the relationship between state ownership and classification shifting.
In order to measure classification shifting, residuals from the model developed by McVay (2006) were used. This model measures classification shifting between core expenses (cost of goods sold and selling, general, and administrative expenses) and special items.
Results: The results show that there is a negative and significant relationship between institutional shareholders and classification shifting and the size of the board strengthens this relationship. But the effect of the proportion of independent directors on the relationship was not significant. There is also a positive and significant relationship between state ownership and classification shifting. While the proportion of independent directors weakens this relationship, the size of the board of directors does not affect the relationship.
Conclusion: The results of this study show that the ownership structure of companies affects the rate of application classification shifting as a method of earnings management. Different kinds of ownership structures can change manager motivations to apply classification shifting. Since institutional ownership provides professional monitoring and control of manager behavior, it has been proven to be an effective corporate governance mechanism. In line with this theoretical foundation, we find a negative relationship between institutional shareholders and classification shifting. On the other side, a positive relationship between state ownership and classification shifting was expected as a result of poor monitoring mechanisms applied by the states to control managers’ behavior. Different aspects of corporate governance such as the board size and independence also can affect these relationships. The findings of the present study should be considered in the decisions of investors and stakeholders of the company because it can provide new evidence on how to use the change in classification as a new way of earnings management. This finding also can be used by auditors for audit risk assessment and audit planning. Since the evaluation of the classification shifting as a method of earnings management is widely ignored by researchers, there are many possible avenues for future research. The effect of other mechanisms of corporate governance on the classification shifting can be studied and on the other hand effect of classification shifting on the value relevance of financial statements the and reaction of investors to financial statements can be investigated.