“Does financial reporting above or below the operating income matter to firms and investors? The case of investment income in China” by Professor Frank Zhang
Professor Frank Zhang
Professor of Accounting
School of Management
We explore a unique regulatory change in 2007 that moves investment income from below the line of operating income to above the line in the income statement. 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 preregula tion 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 mis‐valuation from change of locations of income statement items, but also sheds light on the real impact regulatory change has on firm behavior.