Managerial sentiment and predicted and opportunistic special items

• Published date: 01 July 2023
• Author: Alireza Askarzadeh,Kenneth Yung,Mohammad Najand
• Date: 01 July 2023
• DOI: http://doi.org/10.1002/jcaf.22626

Received:  December Accepted:  February

DOI: ./jcaf.

RESEARCH ARTICLE

Managerial sentiment and predicted and opportunistic

special items

Alireza AskarzadehKenneth YungMohammad Najand

Strome College of Business, Old

Dominion University, Norfolk, Virginia,

USA

Correspondence

Kenneth Yung,Strome College of

Business, Old Dominion University,

Norfolk, VA,USA.

Email: kyung@odu.edu

Abstract

Prior studies suggest that firm managers misclassify core expenses as special

items to influence investors’ perception of firm performance. In this investiga-

tion, we find that managerial decisions regarding misclassification of expenses

are affected by managerial sentiment. Managerial sentiment has a negative

relation with special-item reporting because optimistic (pessimistic) managers

pursue a misclassification that is lower (higher) than what is justified by the

information available to the manager. By decomposing special items into pre-

dicted (PREDSI) and opportunistic (OPSI) components, we find that the effect

of managerial sentiment is pronounced among opportunistic special items. Our

results show that PREDSI (OPSI) has a non-negative (negative) relation with

future firm performance, and special items associated with managerial senti-

ment adversely affect future firm performance. We also find results that suggest

that financial constraints serve as a channel that reinforces the negative asso-

ciation between managerial sentiment and special items. Specifically, financial

constraints impose a limit on how frequently sentiment-driven managers can

misclassify core expenses because misclassifications obscure firm transparency

and harm the credit supply. Our results remain consistent after a battery of

robustness tests.

KEYWORDS

managerial sentiment, opportunistic special items, predicted special items, unjustified beliefs

JEL CLASSIFICATION

G, M, M

1 INTRODUCTION

Excluding special items from non-generally accepted

accounting principles (non-GAAP) earnings and reporting

them as a separate line item on the income statement or

aggregating into another line item with identification via

footnote disclosure have become popular in recentdecades

(Elliott & Hanna, ; Frankel et al., ; Johnson et al.,

; Riedl & Srinivasan, ; Young, ). According to

Govindarajan et al. (), nowadaysmore than % of S&P

 firms report both GAAP and Non-GAAP earnings.

Although many researchers support the idea that special

items are uninformative about future earnings (Fairfield

et al., ; Riedl & Srinivasan, ), Fairfield et al. ()

posit that the exclusion of special items results in a lack of

informative evidence from high profitability firms’ finan-

cial reports. Using only special items in a trading strategy

earns small but statistically significant abnormal returns

302 ©  Wiley PeriodicalsLLC.J Corp Account Finance. ;:–.wileyonlinelibrary.com/journal/jcaf

ASKARZADEH  .303

during a -day window after the announcement of spe-

cial items (Burgstahler et al., ). Taken together, it is

important to explore special items in understanding firm

performance.

Although special items are expected to be transitory

in nature a priori (Fairfield et al., ; Jones & Smith,

), managers have a propensity to shift recurring core

expenses to special items (McVay, ). This propen-

sity differs across firms. Firms that are larger, more in

debt, experience losses, and are subject to financial dis-

tress are more likely to report special items (Velury &

Kane, ). Also, firms with low core profitability have

incentives to report more special items than do firms

with high core profitability (Fairfield et al., ). Dechow

and Ge () document that % of the loss firms in

their investigation of firm earnings quality report special

items. In addition, firms with a less independent board

are more likely to opportunistically exclude non-transitory

special items from non-GAAP earnings (Frankel et al.,

).Among the various determinants, there is evidence

that behavioral biases of managers play an essential role

in reporting special items. For example, CEO narcissism is

associated with opportunistic management of non-GAAP

earnings (Abdel-Meguid et al., ). McVay ()states

that opportunistic behaviors of managers are associated

with shifting recurring expenses from core items to special

items. Brown et al. () argue that managers are affected

by sentiment in a manner similar to that of investors and

exhibit opportunistic behaviors in reporting non-GAAP

earnings. Brown et al. () focus on examining the effect

of investor sentiment on special-itemreporting; they add to

their study a short examination of the effect of managerial

sentiment on the relationship between investor sentiment

and special items. Hribar et al. () define managerial

sentiment as managers’ unjustified beliefs about future

firm outcomes, and present evidence suggesting that man-

agerial sentiment is related to the quality of financial

reporting.

Several factors motivate us to conduct this study. First,

the study by Brown et al. () does not find a significant

relation between managerial sentiment and the reporting

of special items. Brown et al. () however, note that

their results may be biased because of the short interval

(between Q and Q) of the managerial senti-

ment data available for their investigation. Second, prior

studies rely on raw data of special items in their investi-

gations. As the frequency of prior special items increases,

current special items have become predictable (Cready

et al., ). We are thus motivated to use the model of

Cain et al. () to decompose special items into pre-

dicted (PREDSI) and opportunistic (OPSI) components

in order to obtain a better understanding of the associ-

ation between managerial sentiment and special items.

According to Cain et al. (), PREDSI represents eco-

nomically driven special items whereas OPSI contains

opportunistically misclassified recurring expenses from

the past, present, and future. Third, the study by Brown

et al. (), which is comparable to our investigation, uses

hand-collected data that is limited to a sample size of only

 firm-quarter observations of proforma earnings. Our

sample encompasses all the firms included in the Com-

pustat database that have reported special items between

Q and Q (, firm-quarter observations),

the entire period over which managerial sentiment data

are available. Lastly, the literature on the relationship

between managerial sentiment and special items is scarce.

To our knowledge, the study by Brown et al. () is the

only published investigation of the topic. Based on the

above, we conduct this study to add to the literature.

Consistent with prior investigations (Cain et al., ;

McVay, ), this study focuses on income-reducing spe-

cial items. Income-reducing special items are far more

prevalent and persistent compared to income-increasing

special items (Kinney & Trezevant, ). We follow Cain

et al. () by multiplying negative special items by – and

set the value of other special items to zero. We hypothe-

size a negative relation between managerial sentiment and

special items because optimistic (pessimistic) managers

pursue a misclassification that is lower (higher) than what

is justified by the information available to managers. We

also hypothesize that the negative relation between man-

agerial sentiment and special items is pronounced among

OPSI than among PREDSI. We makethe above hypothesis

because OPSI reflects special items that are not economi-

cally driven and are therefore much easier influenced by

sentiment. McVay() posits that shifting core expenses

to special items does not change bottom-line earnings but

overstates “core” earnings. The consensus in the litera-

ture is that special items and future firm performance

are negatively correlated. With special items decomposed

into PREDSI and OPSI, we hypothesize that PREDSI

has a non-negative relation with future firm performance

because predicted special items are economically justified.

We predict OPSI to be negatively related to future firm

performance because OPSI is unrelated to the economics

of the firm, and it is created to opportunistically influ-

ence reported earnings. Weargue that financial constraints

serve as a channel that reinforces the negative relation

between managerial sentiment and special-item report-

ing. Specifically, disclosures made by sentiment-driven

managers obscure firm transparency and cause creditors

to cut back their credit supply, which in turn elevates

financial constraints faced by the firm. Thus, financial

constraints impose a natural restraint on how frequently