Do IPO Firms Misclassify Expenses? Implications for IPO Price Formation and Post-IPO Stock Performance

Abstract

This study investigates whether initial public offering (IPO) firms inflate “core” earnings through classification shifting (i.e., misclassifying core expenses as income-decreasing special items) immediately prior to IPOs. We provide initial evidence that IPO firms engage in classification shifting in the pre-IPO period. Using hand-collected price and share information from IPO prospectuses, we find that pre-IPO classification shifting is positively associated with a price revision from the midpoint of the initial price range to the final offer price, suggesting that pre-IPO classification shifting influences IPO price formation. Furthermore, we find that pre-IPO classification shifting is negatively associated with post-IPO stock returns. Overall, our findings caution investors, auditors, and regulators that classification shifting, a seemingly innocuous accounting maneuver, can mislead investors in their IPO valuation and is associated with post-IPO underperformance. This paper was accepted by Brian Bushee, accounting.

Earnings management by classification shifting and IPO survival

“…Therefore, CS around the IPO may not negatively reflect in future operating performance measured in terms of net profit in a more mechanically reversing way, as would be the case for accrual-based or real profit manipulation (Li and Zhou 2006;Alhadab, Clacher, and Keasey 2015); however, if CS causes a firm to appear more operationally robust than it actually is, a firm engaging in CS should end up performing according to its true (and more negative) potential in the future, leading to lower chances of survivability and success. Indeed, CS may not reverse on the basis of the GAAP net profit reported in future periods; however, it is naturally expected to reverse in terms of future reported operating profit (Cain, Kolev and McVay 2020) and negatively associate with future reported core earnings, with evidence that investors are negatively surprised when misclassified core expenses recur in future periods (Cain, Kolev and McVay 2020;Liu and Wu 2020). This is because, for example, in the case that cash expenses, such as marketing costs, which have been misclassified within special items recur, they should negatively associate with future operating income.…”

Do CEO social connections promote corporate malpractices? Evidence from classification shifting

“…This malpractice aims at inflating core earnings to show them in a better light than warranted and, if detected, CEOs could suffer from reputational losses. Furthermore, classification shifting is likely to have a negative effect on reported core earnings in the future (Liu & Wu, 2021;McVay, 2006). This is because non-recurring items are not likely to occur every year and therefore the misclassification of core expenses as transitory items is unlikely to be sustained on a continuous basis without attracting scrutiny (Anagnostopoulou et al, 2021).…”

“…These assumptions could explain the use of classification shifting: it is a malpractice aimed at inflating core earnings to show them in a better light than warranted and, if detected, CEOs could suffer from reputational losses. Furthermore, similar to accrual earnings management, classification shifting is likely to have a negative impact on future reported core earnings (Liu & Wu, 2021;McVay, 2006). Well-connected CEOs might therefore avoid using classification shifting because it could undermine their reputation as good performers in the following financial years.…”

“…Classification shifting could therefore be appealing for well-connected CEOs to employ as, similar to real earnings management, it is difficult to detect and thereby helps them to meet market expectations with limited reputational harm. However, different from real earnings management, classification shifting is likely to be negatively associated with the subsequent period's operating performance (Gunny, 2010;Jiang et al, 2018;Liu & Wu, 2021;McVay, 2006). Since well-connected CEOs are subject to expectations to achieve good performance not only in the current period but also in the subsequent periods (Malmendier & Tate, 2009), the incentive to inflate earnings via classification shifting might be limited for well-connected CEOs.…”

“…Providing evidence on what drives classification shifting is important as this widespread malpractice misleads investors and lenders about the core performance of the firm by altering the presentation of different elements within the income statement (e.g. Fan et al, 2019;Haw et al, 2011;Liu & Wu, 2021). As emphasised by the US Security Exchange Commission (SEC) "the appropriate classification of amounts within the income statement is as important as the appropriate measurement or recognition of such amounts" (SEC, 2000).…”