Debt financing and classification shifting of private firms

Purpose - This study aims to examine whether debt financing creates incentives for private firms to engage in earnings management via classification shifting. Especially, the authors examine whether debt-induced financial reporting incentives differ depending on the type of debt (i.e. public bonds versus private loans) and whether such incentives are influenced by the characteristics of external auditors (i.e. initial audits and auditor size). Design/methodology/approach - The study uses data on 93,427 Korean private firms from 2001 to 2016. Classification shifting is measured by the positive correlation between non-core expenses and unexpected core earnings estimated with ordinary least squares. Findings - The empirical analyses reveal that private firms engage in classification shifting as do public firms. Importantly, classification shifting is observed only in private firms that have outstanding debt, but not in private firms without debt. Among debt-financing private firms, classification shifting is more prevalent for firms that issue public debt than for firms that only use private debt. In addition, classification shifting of debt-financing private firms is more successful when they are audited by new auditors that are one of the non-Big 4 firms. Research limitations/implications - The study provides evidence of classification shifting in private firms, which is novel to the literature. However, the inferences in the study depend on the validity of the model for detecting classification shifting. Practical implications - This study helps lenders enhance their understanding on the financial reporting behaviors of borrowing firms. The results in this study suggest that lenders should be cautious in using core earnings for their investment decisions. Originality/value - This study contributes to the literature by providing novel evidence of classification shifting in private firms. In addition, the authors contribute to the literature on debt-induced incentives for financial reporting.