The Persistence and Valuation Effects of Classification Shifting

Abstract

Classification shifting is defined in the literature as managers’ intentional classification of certain core expenses as income-decreasing special items with the intent to inflate reported core performance. We show that firms’ propensity to engage in this reporting strategy is persistent over time and relates to its use by peer firms. We also find that this strategy is associated with higher year-ahead firm value and stock returns. As one possible channel through which this valuation effect originates, we find that classification shifting allows firms to increase their debt capacity, consistent with firms shifting risks from shareholders to debtholders. Our tests are implemented using a new firm-year measure of classification shifting that can be broadly applied in many other research settings.

Keywords: Classification shifting; special items; persistence; peer effects; valuation

JEL Classification: M4, M40, M41