Abstract

AbstractPrior studies suggest that firm managers misclassify core expenses as special items to influence investors’ perception of firm performance. In this investigation, we find that managerial decisions regarding misclassification of expenses are affected by managerial sentiment. Managerial sentiment has a negative relation with special‐item reporting because optimistic (pessimistic) managers pursue a misclassification that is lower (higher) than what is justified by the information available to the manager. By decomposing special items into predicted (PREDSI) and opportunistic (OPSI) components, we find that the effect of managerial sentiment is pronounced among opportunistic special items. Our results show that PREDSI (OPSI) has a non‐negative (negative) relation with future firm performance, and special items associated with managerial sentiment adversely affect future firm performance. We also find results that suggest that financial constraints serve as a channel that reinforces the negative association between managerial sentiment and special items. Specifically, financial constraints impose a limit on how frequently sentiment‐driven managers can misclassify core expenses because misclassifications obscure firm transparency and harm the credit supply. Our results remain consistent after a battery of robustness tests.

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