Income Classification Shifting and Mispricing of Core Earnings

This study examines whether the market misprices core earnings (operating income before depreciation and special items) when firms use income classification shifting tactics to boost their core earnings. Previous large sample U.S. studies relate shifted core earnings estimates with future returns and find weak associations. We classify our samples as classification shifters or non-shifters based on various estimation methods and provide strong large sample evidence that the market overprices the core earnings provided by the classification shifters in a nontrivial fashion. While classification shifting tactics do not affect total accruals, we find evidence that the extent of accruals mispricing is stronger for the classification shifters. Our findings are timely given the Security and Exchange Commission's recent concerns of firms' income classification shifting behavior.