Classification shifting and efficiency of corporate investment

Abstract

This study investigates into the real consequences of earnings management by classification shifting via examining its effect on corporate investment efficiency. The underlying expectation is that the way of reporting different items of profit within the income statement should induce information asymmetry between managers and the capital providers about the level of core, and so more likely repeatable, firm performance, and therefore deteriorate the informational environment of firms and associate with efficiency in firm-level investment. We find that classification shifting strongly and positively associates with both over- and under-investment. Investigating into the economic mechanisms through which classification shifting affects efficiency in investment, our results are more pronounced when other information and agency problem-related factors that should protect from inefficient investing are weaker, namely for firms facing greater financial constraints, firms with greater pre-existing information asymmetry and lower auditor quality, and also when opportunistic special items, levels of unexpected investment, and investment opacity are higher. Our study provides evidence on the adverse real consequences of classification shifting, representing a form of earnings management typically considered as relatively innocuous and without any bottom-line performance reversing effects, with reference to a very important firm-level outcome, as is efficiency in investment.