Investing in Your Own Equity: Effects of Fair Value Accounting and Comprehensive Income Recognition on Earnings and Price Volatility
50 Pages Posted: 20 Jul 2004
Date Written: July 20, 2004
Firms can effectively take long or short positions on their own equity by holding treasury shares, contributing their shares to their pension fund, write put or call options on their stock, compensate employees with stock options, or invest in other entities (e.g., other firms, stock indexes) that hold shares of their stock. In each of these circumstances, fair value accounting methods can allow firms to report on these "self-generated" unrealized gains or losses ("UGLs").
In this paper we present a model and experimental evidence indicating that, if investors attend to unrealized gains and losses (UGLs) associated with a firm's own equity, equity price changes reflect through subsequent periods to create high volatility and predictable autocorrelations in price. Our results provide evidence that the reflection-induced volatility is determined by an interaction between the extent of the self-investment and the prominence of the self-generated UGLs on the primary reporting statement (with comprehensive income performance statements providing high prominence).
Keywords: Fair-value accounting, comprehensive income, functional fixation, market efficiency, experiments
JEL Classification: G14, M41
Suggested Citation: Suggested Citation