The effect of analysts’ GAAP earnings forecasts on managers’ classification shifting

Prior research on classification shifting finds that managers opportunistically shift core operating expenses down the income statement into the non-recurring expenses category to improve earnings metrics that are not based on Generally Accepted Accounting Principles (GAAP) without changing the GAAP net income. By using a difference-in-differences design based on the availability of analysts’ GAAP earnings forecasts following the enactment of the Sarbanes-Oxley Act (SOX), we find that the introduction of analysts’ GAAP forecasts significantly attenuates the positive association between unexpected core earnings and non-GAAP exclusions for firms with GAAP forecasts. This association strengthens for control firms for which analysts do not issue GAAP forecasts. Our results indicate that classification shifting, which commonly results in a simultaneous inflation of core earnings and non-GAAP exclusions, has been effectively mitigated consequent to the transparency on forecasted non-GAAP exclusions brought about by the growth of analysts’ GAAP forecasts. Our study contributes to the literature by identifying a new mechanism for effectively constraining classification shifting after SOX. Moreover, our findings have important implications for standard setters and regulators advocating for greater transparency in financial information, and emphasize the value of the analyst as an effective information intermediary to capital markets.