Limited Attention to Detail in Financial Markets

Abstract

We show that financial analysts and market investors reduced valuations following a large drop in accounting earnings that did not reveal new information about firm fundamentals. FAS 123-R required firms to begin expensing option compensation in income statements, instead of disclosing costs only in footnotes. We exploit that FAS 123-R’s compliance dates were staggered quasi-randomly based on firms’ fiscal year-ends. Firms that expensed options experienced a significant reduction in earnings growth, but their underlying profitability was unchanged. These firms were more likely to miss analysts’ earnings forecasts, relative to firms that did not yet expense options. Analysts also more often revised down their recommendations, resulting in significant stock price underperformance. Our results are consistent with the limited attention hypothesis: Analysts and investors overvalue firms when value-relevant information is less accessible.

Keywords: Limited attention, option expensing, analyst recommendations, earnings forecasts, FAS 123-R

JEL Classification: G41, G24, G18