The Credibility of Accounting Classification: Determinants and Consequences

Abstract

In this study we report the results of a laboratory experiment in which we examine whether the credibility of management's balance-sheet classification of hybrid securities as liabilities or equity is a joint function of (1) the level of classification discretion in the reporting environment, (2) whether management's classification choice is consistent or inconsistent with reporting incentives, and (3) management's reporting reputation. Our results suggest that when classification is mandated, credibility is unrelated to management's reporting reputation and whether management's classification choice is consistent or inconsistent with incentives. When classification is discretionary, financial report users consider management's classification choice more credible when it is inconsistent with incentives. Users are sensitive to management's reporting reputation only when classification is discretionary and management's classification choice is consistent with incentives. We also find that the association between the credibility of management's classification choice and user assessments of financial performance depends upon whether the classification is consistent or inconsistent with incentives. Finally, our results suggest that a good reporting reputation leads to higher financial performance assessments in both mandated and discretionary reporting environments. Implications, limitations, and future research are also discussed.

Keywords: credibility, financial reporting reputation, discretionary disclousre, hybrid securities, financial statement analysis

JEL Classification: D80, M41, M45, L14