The impact of carbon risk on classification shifting in the presence of internal corporate governance mechanisms

Purpose This study aims to investigate the influence of carbon risk (CR) on classification shifting (CS), focusing on how environmental pressures affect financial reporting practices. It also examines the moderating role of corporate governance in mitigating CS, particularly in firms with high carbon emissions. Design/methodology/approach CS is measured using McVay’s (2006) proxy. Carbon risk is proxied by current and lagged values of CO2 emissions, carbon intensity and industry-adjusted carbon risk scores. The analysis is based on a panel of 511 publicly listed UK firms over the 2012–2023 period, yielding 5,124 firm-year observations. The sample is segmented into higher and lower polluting firms, and into pre- and post-Paris Agreement periods, to capture regulatory effects. Regression techniques with endogeneity controls and robustness checks are applied. Findings Firms with elevated levels of current and lagged carbon risk are more likely to engage in CS, reclassifying operating expenses to inflate core earnings without affecting net income. Strong corporate governance mechanisms help mitigate this practice. The moderating effect of governance becomes more pronounced after the 2016 Paris Agreement, particularly among high-emission firms. These results reflect the increasing regulatory expectations and stakeholder attention to sustainability accountability. Research limitations/implications This study contributes to the earnings management literature by identifying carbon risk as a determinant of CS. It underscores the importance of internal governance mechanisms in preserving reporting quality under environmental scrutiny and regulatory change. Originality/value To the best of the authors’ knowledge, this is one of the first studies to explore the link between carbon risk, CS and corporate governance. By addressing this gap, the paper offers novel insights into how environmental challenges influence earnings management and how governance can help preserve the integrity of financial reporting.