Abstract
Accounting regulations require firms to separately disclose the profits and losses from discontinued operations. These discontinued operations are typically excluded from the definition of income used by investors, analysts, and others. Barua, Lin, and Sbaraglia (2010) show that managers manipulate earnings by shifting core expenses into discontinued operations. In light of recent changes in the regulations pertaining to this item, we reexamine this finding. The new rules, which change the criteria for what can be considered discontinued and the associated disclosure requirements, substantially reduce any significant evidence of earnings management using discontinued operations. A decline in the manipulation of large negative discontinued operations drives this reduction. We also find that the new rules decrease the frequency and persistence of discontinued operations.
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Notes
Extraordinary items were treated similarly but were uncommon for at least a decade prior to their elimination by the FASB in 2015 (Accountings Standards Update 2015–01). Between 2005 and 2014, 11.5% of Compustat firms reported discontinued operations, while only 2.1% of firms reported extraordinary items. The frequency of extraordinary items falls to less than 1% in the 2 years before its elimination, which corresponds to the first half of our sample period.
For example, Deloitte, in its comment letter on the exposure draft, noted that its personnel “… are concerned that the terms in the definition may be misunderstood and inconsistently applied and thus may not always be applied in a manner consistent with the intended principle”(Morris and Velanand 2014).
Under the new rules, firms must disclose in the footnotes the major line items associated with the discontinued operation’s income or loss and the major classes of assets and liabilities associated with the component to be or already discontinued. Firms must also disclose either the operating and investing cash flows associated with the discontinued operations or depreciation, amortization, and capital expenditures.
We use annual data, which is consistent with the approach of Barua et al. (2010). As an additional (untabulated) analysis, we rerun our tests using quarterly data and find qualitatively similar results.
This calculation assumes that the entire value of negative discontinued operations was managed. Therefore these estimates represent the upper bound of the percentage of firms that shift core expenses to discontinued operations to achieve the performance benchmarks that we evaluate.
The same approach is used by Barua et al. (2010).
In untabulated analyses, we use a subsample approach (running the analysis separately on the pre- and post-regulatory change periods). We similarly find that this type of earnings management is no longer significant after the rule change.
Consistent with the less powerful test Barua et al. (2010) run at first, we also perform the analysis on all discontinued operations. Those results support our main findings.
We consider two alternative specifications. First, we include all terms interacted with POST. Second, we run the analyses with firm fixed effects. The results (untabulated) show that our variables of interest are qualitatively similar, and we observe control variables with coefficients that are comparable to the results of Barua et al. (2010).
The results are available from the authors upon request.
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Ji, Y., Potepa, J. & Rozenbaum, O. The effect of ASU 2014–08 on the use of discontinued operations to manage earnings. Rev Account Stud 25, 1201–1229 (2020). https://doi.org/10.1007/s11142-020-09535-y
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DOI: https://doi.org/10.1007/s11142-020-09535-y