A Theory of Classification

Abstract

The decision to classify line items as special items or core earnings is designed to signal item persistence. Using information other than persistence, such as the sign of the line item, is known as classification shifting. Although classification shifting is widely seen as earnings management, we demonstrate in a simple classification and reporting game that the commonly observed reporting patterns arise when no misreporting occurs. In fact, signaling persistence rather than misreporting explains additional empirical findings that a misreporting story cannot address. Overall, strategic classification imposes a surprising amount of structure on reports, and we argue that it would be ill-advised to set policy based on a presumption that classification shifting is earnings management.