Does financial reporting above or below operating income matter to firms and investors? The case of investment income in China
- 1.8k Downloads
We explore a unique regulatory change in China in 2007 that moves investment income in an income statement from below the line of operating income to above the line. We find that, post-regulatory change, firms report high investment income when core earnings (operating income excluding investment income) are low and vice versa. Investment income and core earnings exhibit a significantly negative correlation every year post regulation, in contrast to a significantly positive correlation beforehand. We also find that investors do not fully see through the change. Before the regulation, both core earnings and investment income are positively correlated with contemporaneous stock returns and uncorrelated with future stock returns, suggesting appropriate pricing of the information. However, afterward, the results on core earnings are similar to those in the pre-regulation period, but investment income is negatively correlated with future stock returns, implying that the stock market overreacts to the information in investment income in the contemporaneous year.
KeywordsCore earnings Investment income Operating income Mispricing
JEL classificationM40 M41 G12 G14
We thank two anonymous referees, Richard Sloan (editor), and participants at workshops at Fudan University, Queen’s University, the University of Illinois at Chicago, Hong Kong University, and the 2016 Accounting Symposium at Hong Kong University of Science and Technology for helpful comments and suggestions. Professor Luo is grateful for financial support of Tsinghua University Initiative Scientific Research Program. Professor Shao is grateful for financial support of National Natural Science Foundation of China (No.71702162).
- Abdel-Khalik, A. R., & McKeown, J. (1978). Understanding accounting changes in an efficient market: Evidence of differential reaction. The Accounting Review, 53(4), 851–868.Google Scholar
- Alfonso, E., Cheng, C. S., & Pan, S. S. (2015). Income classification shifting and mispricing of Core earnings. Journal of Accounting, Auditing & Finance, 1–32.Google Scholar
- Bartov, E. (1993). The timing of asset sales and earnings manipulation. The Accounting Review, 68(4), 840–855.Google Scholar
- Hand, J. R. M. (1990). A test of the extended functional fixation hypothesis. The Accounting Review, 65(4), 740–763.Google Scholar
- Schipper, K. (1989). Commentary on earnings management. Accounting Horizons, 3(4), 91–102.Google Scholar
- Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(3), 289–315.Google Scholar