Does financial reporting above or below operating income matter to firms and investors? The case of investment income in China
Review of Accounting Studies, 2018 (23), 1754-1790.
54 Pages Posted: 27 Aug 2016 Last revised: 2 Jun 2019
Date Written: May 10, 2018
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 tend to 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 in the post-regulation period, in contrast to a significantly positive correlation in the pre-regulation period. We also find that investors do not fully see through the change in the information content in investment income. In the pre-regulation period, both core earnings and investment income are positively correlated with contemporaneous stock returns and uncorrelated with future stock returns, suggesting that the market appropriately prices the information in core earnings and investment income. However, in the post-regulation period, 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. Overall, our evidence not only highlights potential misvaluation from changes of location of income statement items, but also sheds light on the real impact of regulatory change on firm behavior.
Keywords: core earnings, investment income, operating income, mispricing
JEL Classification: M40, M41, G12, G14
Suggested Citation: Suggested Citation