The Real Consequences of Classification Shifting: Evidence from the Efficiency of Corporate Investment

Abstract

This study investigates the real consequences of classification shifting by examining its effect on corporate investment efficiency. The underlying expectation is that the ways of reporting different profit items within the income statement should increase information asymmetry between managers and capital providers regarding the level of core and, so, more likely repeatable firm performance. We anticipate that classification shifting will aggravate agency problems and distort managers’ own perceptions of their firms’ sustainable profitability, resulting in imperfect investment-related information sets for them, ultimately leading to inefficient investing. We find that classification shifting strongly and significantly decreases the responsiveness of investment to growth opportunities and is, thus, associated with less efficient investing. After investigating the economic mechanisms explaining this association, our results are more pronounced when other information and agency problem-related factors that should protect against inefficient investing are weaker, and also for firms whose managers have fewer opportunities to learn from peers, which could alleviate potential classification shifting-related distortion effects on managerial perceptions. Our study provides evidence on the adverse real consequences of classification shifting, a form of earnings management without any reversing effects for bottom-line future performance, with reference to a very important firm-level outcome; namely, efficient investing.