Do Investors Price Classification Shifting? An Indian Evidence

Abstract

This study examines whether investors respond to classification shifting - an earnings management strategy where recurring items are misclassified as non-recurring to inflate core earnings - in the Indian capital market. Using a sample of 3085 firms listed on the Bombay Stock Exchange from 2000 to 2024, we investigate the pricing implications of both revenue and expense shifting through portfolio analysis and Fama-MacBeth cross-sectional regressions. Consistent with prior literature, we find that firms engaging in classification shifting, particularly revenue shifting, experience abnormal stock returns, suggesting investors demand a higher premium for holding the stocks of revenue shifters. However, expense shifting shows inconsistent pricing effects, highlighting potential differences in investor attention or detectability. Extending prior work, we explore the moderating role of corporate governance mechanisms - namely, the frequency of audit committee meetings, board meetings, and the proportion of independent directors - on the relationship between classification shifting and stock returns. Our results reveal that firms with stronger governance structures experience attenuated market mispricing, indicating that effective internal oversight can serve as a counterbalance to opportunistic reporting. These findings offer new insights into how internal governance moderates the informativeness and credibility of reported earnings in emerging markets.