Income Classification Shifting and Mispricing of Core Earnings

Abstract

This study examines whether the market misprices core earnings (operating income before depreciation and special items) when firms use income classification shifting tactics to boost their core earnings. We find that the market's expectation of core earnings' persistence is higher than the actual reported earnings persistence of firms that have shifted their core earnings. We also find that core earnings are more negatively associated with future returns for shifters than for non-shifters. Overall, we find strong evidence that the market overprices shifters' core earnings. These results are robust to controlling for earnings management and real earnings management, endogeneity and self-selection, and using alternative measures of classification shifting. Our findings are timely given the Securities and Exchange Commission's recent concerns of firms' income classification shifting behavior.

Female CEOs and Core Earnings Quality: New Evidence on the Ethics Versus Risk-Aversion Puzzle

“…We focus on classification shifting since the extant literature (e.g., Fan et al 2010;McVay 2006) has already documented that some firms use classification shifting to deceive investors, particularly when they are constrained from using accruals. In addition, Alfonso et al (2015) show that investors tend to misprice underlying earnings that have been deliberately overstated by classification shifting, and thereby suggesting that investors, particularly small investors (Allee et al 2007), can be at risk of being misled by classification shifters' opportunistic practices.…”

“…In particular, past studies (Cumming et al 2015;Peni and Vahamaa 2010;Sun et al 2017) have focussed on accruals-based earnings management (AEM) that became a costly method rather than other, arguably less costly, methods, particularly after financial scandals in the early 2000s, such as Enron and WorldCom, which were followed by the issuance of some restrictive regulations, such as the 2002 Sarbanes-Oxley (SOX) (Chen et al 2012;McNichols 2000;Stubben 2010). Accordingly, AEM has, arguably, become costly due to its detection cost (Abernathy et al 2014;Alfonso et al 2015), which in turn might lead managers to seek other earnings management methods that are relatively more difficult to detect if they hope to garner the benefit of earnings management (Abernathy et al 2014;Lo 2008;Roberts 2016, 2017).…”

“…A priori, if women are more risk-averse than ethical, then we conjecture that, when facing the possibility of costly legal action, they are more likely to shift to a more subtle, less risky and difficult-to-detect corporate activity (Abernathy et al 2014;Alfonso et al 2015), albeit equally un-ethical Roberts 2016, 2017). The opposite may hold if women are more ethical than men are.…”

“…As classification shifting 4 is both less risky and un-ethical, but rarely studied (Abernathy et al 2014;Alfonso et al 2015), it allows us to make unique contributions to the existing literature by testing our propositions. Consequently, the main objective of this study is to investigate the effect that the gender of the CEO 5 has on earnings management, using classification shifting.…”

“…Nevertheless, only few studies have investigated classification shifting, and those that have done so, have suggested that firms employ it as a tool to meet their earnings' targets, particularly in firms constrained from using accruals to inflate their earnings (e.g., Barua et al 2010a;Fan et al 2010;Haw et al 2011;McVay 2006). A major limitation of the few existing studies (Abernathy et al 2014;Alfonso et al 2015;Fan et al 2010;Haw et al 2011;Roberts 2016, 2017) is that they have often treated all CEOs engaged in classification shifting as the same, irrespective of their background, specifically their gender origins. Extant research has shown that CEOs' reputation, financial expertise, tenure, and age have an impact on their motivation and ability to engage in earnings management (i.e., Ali and Zhang 2015;Francis et al 2008;Huang et al 2012;Jiang et al 2013).…”