Controlling Shareholders' Tax Incentives and Classification Shifting*

Abstract

Although prior studies provide evidence on the financial reporting incentives to inflate core earnings through classification shifting (e.g., shifting core expenses to income‐decreasing noncore items), few examine the tax‐related incentive to report lower core earnings through classification shifting. We examine the effect of controlling shareholders' tax incentives on firms' classification shifting using the introduction of a tax law in Korea that imposes a gift tax on controlling shareholders based on firms' reported core earnings. This tax law creates incentives for managers to report lower core earnings through classification shifting, even though doing so would incur significant financial reporting costs. Using a difference‐in‐differences research design, we find that firms with controlling shareholders subject to the gift tax exhibit a significant decline in classification shifting in the post‐tax period, while those not subject to the tax do not. We also predict and find that the extent to which managers reduce classification shifting decreases with financial reporting costs and increases with the tax benefits. Overall, our results indicate that firms forgo financial reporting benefits associated with reporting higher core earnings for the tax savings of their controlling shareholders.

Classification Shifting and Future Stock Price Crash Risk

“…Our findings support the widely accepted view and are consistent with new findings (Chung et al. 2021; Hwang et al. 2022; Dao et al.…”

“…Given the evidence of negative market reaction to the reversal of special items (McVay 2006;Cain et al 2020) and mispricing on classification shifting (Alfonso et al 2015), our study extends the potential negative economic consequence of the stock price by documenting the evidence of mispricing on the shifter's core earnings to subsequent crash risk. Our findings support the widely accepted view and are consistent with new findings (Chung et al 2021;Hwang et al 2022;Dao et al 2022), suggesting classification is a tool to manipulate a firm's core earnings performance.…”

Do inflowing sophisticated investors induce classification shifting? New evidence from market liberalisation in China

“…Specifically, we took the SHSC programme as an exogenous shock to examine the effect of inflowing sophisticated investors from Hong Kong on classification shifting of listed firms in Mainland China's A-share market. Following Chung et al (2021) and Lin et al (2020), we developed the following model to test our hypotheses:…”

“…We address this concern of a timelag-related effect in the robustness checks of Section 7.5. We follow prior studies of classification shifting (McVay, 2006;Fan et al, 2010Fan et al, , 2019Lin et al, 2020;Chung et al, 2021) and use a three-way interaction term (SI × TREAT × POST) in a DID model to test our hypotheses. As discussed previously, the detection of classification shifting relies on the existence of a positive relationship between unexpected core earnings (UE_CE) and income-decreasing special items (SI).…”