Misclassification of Negative Core Earnings and Signal-Driven Price Association

This paper provides evidence that managers strategically report large negative special items (NSP hereafter) when the current year's expected core earnings deviate from the previous year's reported core earnings benchmark. The strategic reporting of NSP is consistent with misclassifying negative core earnings (operating expenses and losses) as NSP and is more likely associated with poor financial reporting firms. Decomposing NSP into misclassified negative core earnings and real NSP reveals that only the noneconomically-based component of NSP is associated with subsequent financial restatements. The misclassification practice is consistent with a conjecture by managers that misclassified negative core earnings receive less valuation implications. Consistent with this conjecture, I find that the misclassified component forecasts earnings similar to reported core earnings; however it receives an ERC (earnings response coefficient) that is inconsistent with its forecasting ability. Further results show that changes in stock price association with NSP are mainly driven by a “noisy” reporting signal of misclassification