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 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 post regulation, in contrast to a significantly positive correlation beforehand. We also find that investors do not fully see through the change. Before the regulation, both core earnings and investment income are positively correlated with contemporaneous stock returns and uncorrelated with future stock returns, suggesting appropriate pricing of the information. However, afterward, 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.

Introduction

There is a growing literature on how the location of income statement items affects firms’ opportunism and investors’ reaction to this financial information (Lee et al. 2006; Bartov and Mohanram 2014). For example, Lee et al. (2006) show that, even though SFAS No. 130 encourages firms to report comprehensive income on a performance statement, property-liability insurers with a tendency to manage earnings through realized gains and losses from marketable securities (Bcherry pickers^) are more likely to report comprehensive income in a statement of equity, a less salient disclosure. Bartov and Mohanram (2014) find that repositioning gains/losses from early debt extinguishments from below the line in the income statement to above it affects the market response to this item. This suggests investors may value an earnings component differently depending on where it appears in the income statement, even though its economic content remains the same. These studies have focused on specific industries or on specific transactions. In this paper, we explore a unique setting of regulatory change that affects the income statement presentation of a far more ubiquitous transaction—gains/losses from investment, an item more likely to be used as a tool of earnings management. China’s adoption of new IFRS-based accounting standards in 2007 moved investment income from below the line of operating income to above the line in the income statement. Operating income measures the firm’s ability to generate profits from continuing and core business. The Chinese Securities Regulatory Commission (CSRC) views operating income as a highly important performance metric and requires all listed firms to present it in the key summary of accounting data that precedes financial statements, thus delivering a clear image of a firm’s core profitability. We posit that both firms and investors respond to this regulatory change, interconnecting firms’ earnings management and investors’ pricing of investment income. Specifically, if the amount of investment income is subject to management discretion, as with which investments to sell and when, firms may have incentives to manage operating income via investment income.1 We further explore whether the stock market fully incorporates the information in investment income, as changing its location in the income statement could induce firms to alter their behavior, thus modifying its information content. The Chinese setting of regulation change is unique in two ways. First, China is among the largest and fastest growing economies and capital markets in the world. Understanding firm and investor behavior there is crucial to academics, practitioners, and policymakers. Second, while studies have identified how firms opportunistically respond to regulatory changes or how investors’ pricing of accounting information can be affected by the location of information in the income statement, this situation is likely to be exacerbated in China, given the country’s weak corporate governance and lower level of investor sophistication (Kun-Chih et al. 2016).