Net Income Measurement, Investor Inattention, and Firm Decisions

Abstract

This paper studies the effect of net income measurement on firms' stock prices and investment decisions when investors have limited attention. We build a model to analyze and compare the effects of two income measurement regimes: one includes changes in unrealized gains and losses (UGL) from financial assets (i.e., the inclusive regime), and the other excludes them (i.e., the exclusive regime). The model identifies conditions under which managers reduce investment in financial assets under the inclusive regime. We empirically test the model predictions by exploiting the implementation of ASU 2016-01, which requires publicly traded firms to incorporate changes in unrealized gains and losses from equity securities into net income. Using US insurance company data, we find that insurers' stock returns react more strongly to changes in UGL on equity securities after the rule change. Using a difference-in-differences approach, we find that, by 2020, publicly traded insurance companies cut investments in publicly traded stocks by almost 20%. Insurers that had more analyst coverage were less affected by the rule change. Our results highlight the impact that investor inattention has on firms' stock prices and investment decisions.

Keywords: Net income components, investor inattention, ASU 2016-01, investment allocation decisions

JEL Classification: G11, G14, G22, G30, M41