The real consequences of classification shifting: Evidence from the efficiency of corporate investment

Posted by ARC Commitee - Apr 22, 2023
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In our study, we investigate the real consequences of classification shifting (CS), a form of earnings management, by examining its effect on corporate investment efficiency. CS refers to the deliberate and improper inclusion of core expenses in negative special items (Joo & Chamberlain, 2017) and represents a form of non-bottom-line profit manipulation that increases core earnings without affecting bottom-line profit (e.g., Haw et al., 2011; Joo & Chamberlain, 2017; McVay, 2006). Firms have incentives to engage in this practice because core earnings are more informative than non-core ones in predicting future earnings (e.g., Haw et al., 2011; McVay, 2006). Despite the pervasive use of CS, there is, however, limited research that investigates the consequences of this financial reporting practice, with limited exceptions (Anagnostopoulou et al., 2021; Liu & Wu, 2021), focusing, however, on the consequences of CS for future firm success within the IPO context.

 

In our paper, we extend limited research on the consequences of CS by departing from the IPO context and examine whether this practice is associated with firm-level investment efficiency. We directly test for the real consequences of CS—a widespread practice of misclassifying income statement line items—by focusing on all firms, rather than on firms that have recently engaged in IPOs only. We hypothesize that CS can be negatively associated with firm investment efficiency for two reasons. First, we expect that the ways of reporting different profit items within the income statement should increase information asymmetry between managers and capital providers regarding the level of core, and so more likely repeatable, firm performance. Second, we anticipate that classification shifting will aggravate agency problems and distort managers’ own perceptions of their firms’ sustainable profitability, resulting in imperfect investment-related information sets for them, ultimately leading to inefficient investing.

 

We examine our research question for North American nonfinancial firms between 1990–2019 by measuring CS following Joo and Chamberlain (2017), based on the methodology established by McVay (2006). We measure investment efficiency by examining the sensitivity of a firm’s investment to its growth opportunities (e.g., Asker et al., 2015; Badertscher et al., 2013; Shroff et al., 2014). Higher sensitivity of investment to growth opportunities indicates more efficient investing, as investment should be more responsive to growth opportunities when adjustment costs, i.e., information frictions and agency problems, are low (Hubbard, 1998; Shroff et al., 2014). We find that firm engagement in CS strongly decreases the sensitivity of investment to growth opportunities, suggesting that this practice has a negative effect on firms’ investment efficiency. After investigating the economic mechanisms explaining this association, our results are more pronounced when other information and agency problem-related factors that should protect against inefficient investing are weaker, and also for firms whose managers have fewer opportunities to learn from peers, which could alleviate potential classification shifting-related distortion effects on managerial perceptions.

 

Our study provides evidence on the adverse real consequences of CS, a form of earnings management without any reversing effects for bottom-line future performance, with reference to a very important firm-level outcome, namely efficient investing. We show that CS, or a form of earnings management which also less likely to attract the scrutiny of auditors and regulators (Athanasakou et al., 2009; Cain et al., 2020; McVay, 2006), is not the low consequence form of financial misreporting that it has previously been considered to be, as it is negatively and significantly associated with the efficiency of investment. Understanding the consequences of CS, particularly with reference to investment efficiency is important as this efficiency plays a key role in future firm performance (Cai & Zhang, 2011; Titman et al., 2004).

 

Past research has mainly focused on how firms’ own production of information influences their investment decisions, and has largely neglected other sources of information which could also help reduce adverse selection costs with a beneficial effect on investment efficiency (Roychowdhury et al., 2019). However, we explicitly identify other sources of accounting information that can influence a firm’s own adverse selection costs and investment decisions, as we examine the effect of disclosures from peers on efficient investing, by showing that the latter favor managerial learning from such disclosures. Overall, our paper contributes to the literature on the real effects of accounting (Leuz & Wysocki, 2016; Roychowdhury et al., 2019; Shroff, 2020), by examining whether the misclassification of items within the income statement is associated with efficient investing, and provide additional insights regarding the impact of earnings manipulation on efficient investing when this manipulation affects operating profit reporting rather than the bottom line.

 

This paper, by Seraina C. Anagnostopoulou and Kamran T. Malikov, is forthcoming at EAR:

https://www.tandfonline.com/doi/full/10.1080/09638180.2023.2200199