A Principle of Classification

Abstract

We study a firm's decision to classify transactions as recurring or nonrecurring in a setting with no fixed classification scheme, but with the following principle: transactions classified as recurring must be more persistent than those classified as nonrecurring. This principle corresponds to existing classification standards. We find that the firm’s optimal classification strategy has a simple form: maximize the product of the (absolute) total of income-reducing nonrecurring and the total income-increasing recurring items. We characterize the possible firm values consistent with a report, and provide a measure of how opaque a firm’s valuation is given its classification choice.