Classification Shifting In Decision Making

INTRODUCTION

The use of classification shifting by managers in reporting revenue, gains and losses and expenses on the income statement has been generating a lot of attention from financial media, regulators and academic researchers in the recent years. Classification shifting as a practise involves manipulating the income statement by reporting gains and losses, expenses and revenue in other areas of the income statement other than where they should have appeared appropriately under “Generally Accepted Accounting Practice’’. The focus of this paper is to determine if the market overvalues core earnings as a result of classification shifting and provide evidence of negative consequence to shareholders when managers employ the use of classification shifting to increase core earnings.

Prior studies investigates various aspect of Non-GAAP reporting, like the masking of true economic performance in which, McVay (2006) hypothesizes that managers have the incentives to report core expenses which, comprises of cost of goods sold, selling, general and administrative expenses, as income-decreasing special item in an attempt to inflate core profitability. The strong preference toward “street earnings” over GAAP earnings also contributes to managers employing the use of classification shifting (Bradshaw, and Sloan 2002). More studies highlighted the opportunistic use of non-GAAP reporting to influence analysts’ forecast and investors’ decision-making (Bhattacharya et al. 2007; Black et all. 2010: Doyle et al. 2013). I hope to add to the body knowledge by providing evidence regarding mispriced core earnings and its misleading negative impact on shareholders. The case of Enron, an energy company in America comes to mind, as they were able to ...

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...core expenses and losses the following year (t + 1). The resultant effect of this will lead to lower persistence core earnings, as classification shifters are unlikely to persistently continue shifting expenses and losses from core expenses. Doyle et al. (2003) find that greater expenses shifted from pro forma earnings can predict lower future cash flow; however, the market fails to fully appreciate the implications of lower future cash flow on future firm value. A hedge portfolio test based on the ranking of exclusions and a regression test that control for risks and other anomalies, reveals that high excluded expenses are associated with significantly negative abnormal return for up to three years. These results suggest that the core earnings reported by firms can mislead the market.

H1. FIRMS MISPRICE CORE EARNINGS

H2. MISPRICED CORE EARNINGS MISLEAD INVESTORS