Income Classification Shifting and Financial Analysts’ Forecasts

Abstract

Income classification shifting involves misclassifying core expenses into non-core items to boost core earnings. Managers engage in classification shifting because they believe they can manage the perceptions of investors and financial analysts. We examine analysts’ earnings forecasts to determine whether analysts can identify classification shifting ex post and how they respond to shifted income statement components. Analysts play a role as information intermediaries between firms and investors. We find that analysts respond less to increased core earnings from classification shifting. However, analysts fail to gauge the full impact of classification shifting, leading to more optimistically biased and less accurate forecasts.

The Association Between Audit Quality and Earnings Management Using Classification Shifting

“…Changing the classification of income statement implies the deliberate misclassification of the management into non-recurring items that include the cost of goods sold, special costs and discontinued operations, such as cost of goods sold, sales and general administrative expenses. This form of EM is accepted as a third tool of earnings management in recent studies in the literature (Pan, 2014). Shifting the classification of income statement items, another tool of earnings management, involves misclassification of line items in the income statement in order to increase core earnings (Barua & Zhao 2014).…”

“…Classification shifting in the income statement provides significant advantages to management compared to accrual management and real activity management (McVay, 2006;Barua et al, 2010;Pan, 2014). One of these advantages is that changing the classification is very difficult to detect.…”