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

See all articles by Mei Luo

Mei Luo

Tsinghua University - School of Economics & Management

Shuai Shao

Zhejiang University

Frank Zhang

Yale School of Management

Date Written: May 10, 2018

Abstract

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

Luo, Mei and Shao, Shuai and Zhang, Frank, Does financial reporting above or below operating income matter to firms and investors? The case of investment income in China (May 10, 2018). Review of Accounting Studies, 2018 (23), 1754-1790.. Available at SSRN: https://ssrn.com/abstract=2830102 or http://dx.doi.org/10.2139/ssrn.2830102

Mei Luo

Tsinghua University - School of Economics & Management ( email )

Weilun Building 201B
School of Economics and Management
Beijing, Beijing 100084
China
8610-62773185 (Phone)

Shuai Shao

Zhejiang University ( email )

Zijingang Campus
School of Management
Hangzhou, Zhejiang 310058
China

Frank Zhang (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
365
Abstract Views
1,318
rank
81,217
PlumX Metrics