Limited Attention to Detail in Financial Markets

Abstract

We show that firm valuations fell after a key expense became more visible in financial statements. FAS 123-R required firms to deduct option compensation costs from earnings, instead of disclosing them only in footnotes. Firms that granted high option pay experienced a significant earnings reduction, while fundamentals remained unchanged. These firms were more likely to miss analysts’ earnings forecasts, received recommendation downgrades, and experienced valuation declines. Effects were strongest among firms whose analysts and shareholders faced greater cognitive constraints on estimating option costs. These findings are consistent with market participants exhibiting limited attention to option costs prior to FAS 123-R.

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

JEL Classification: G41, G24, G18