The Effect of Classification Shifting on Firm Success

Abstract

The study examines the effect of earnings management by classification shifting on firm success, focusing on the survival of newly listed firms. We argue that shifting income-decreasing expenses from core to special items should negatively associate with future operating performance because of improper signaling of actual repeatable core profitability. We find that classification shifting strongly and negatively affects future Initial Public Offering (IPO) success and survival. We further identify the economic mechanisms that drive this finding and observe that our results are mitigated when the quality of external corporate governance alleviating agency concerns is stronger, also for IPO firms operating within stronger business contexts. Therefore, in an environment that facilitates firm survivability, the existence of weaker than reported sustainable performance may not end up materializing in the form of lower firm survivability as these factors aid firms’ continuing operations from a business perspective. Our findings provide evidence of the longer-term implications of a method of earnings management that has long been considered “soft” and without any longer-term reversing consequences.