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Review of Accounting Studies

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09-07-2018

Does financial reporting above or below operating income matter to firms and investors? The case of investment income in China

Authors: Mei Luo, Shuai Shao, Frank Zhang

Published in: Review of Accounting Studies | Issue 4/2018

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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.

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To validate the assumption that firms have incentives to manage operating income, we examine the valuation implications of as-reported operating income and other income. Conceptually, operating income represents a firm’s core performance and thus should be valued highly by investors. In contrast, other income is more likely to be transitory and should be valued less by investors. To examine the relationship between contemporaneous stock returns and operating income and other income, we consider both the levels and the changes regressions. In untabulated analysis, we find that, in both specifications, operating income is highly priced in the market whereas other income is not. We also find that executive compensation is positively correlated with as-reported operating income and uncorrelated with other income, consistent with the idea that executives are rewarded on recurring operating income but not on transitory other income. Both sets of results lend support to the idea that firms have incentives to manage operating income.

Unrealized gains or losses from trading securities are a newly introduced item in the post-regulation period, so we cannot compare the information content of this item in the pre- versus post-regulation periods.

However, some studies argue that the differing market reactions to disclosed items versus recognized items are attributable not to the form of presentation but to the reliability of disclosures, institutional ownership, or analyst following (Bratten et al. 2013; Yu 2013).

Some key differences are that ASBE 8 prohibits the reversal of all impairment losses (whereas the International Accounting Standards allow the reversal of most impairment losses) and state-controlled entities are not all regarded as related parties simply because they are controlled by the state (since all state-owned Chinese companies are independent legal persons).

The Securities Regulatory Committee of China requires all companies in China, except financial firms, to follow the same format in preparing financial statements with identical account names in both the pre- and post-regulatory change period.

The other changes to the format of the income statement involve new requirements for presenting comprehensive income and the position of reporting minority interests.

See page 520 of the Interpretation Guidance of Chinese Accounting Standards (2010), which is published by the Accounting Regulatory Department of the Ministry of Finance. This interpretation guidance offers detailed explanations and specific examples for the standards.

Under the Old GAAP, investment income covers almost the same categories of business transactions, except that the major investments are debt and equity securities investments without the concept of financial assets or financial liabilities. Additionally, when short-term investments drop in value below cost, the impairment loss is included in investment income and increase in market value is not recognized.

A split-share structure was adopted when firms first issued stock in the domestic Chinese market. While shares owned by individuals are tradable in the stock market, shares owned by state and legal persons are nontradable, accounting for two-thirds of total shares. In April 2005, to better align the interests of block and minority shareholders, the Chinese government initiated a reform to convert all nontradable shares into tradable shares. By the end of 2007, over 97% of total Chinese A-share firms had completed the reform (Li et al. 2011). However, after a firm completes the reform, the originally nontradable shares are subject to lock-up periods of 12 months or longer depending on the ownership of the nontradable shares. When shares of listed firms become tradable, managers have larger discretion over selling such newly tradable shares to manage investment income.

As of September 2017, WRDS has financial data up to 2014 and return data up to 2015, so we supplement the WRDS data with the 2015 financial data and obtain the 2016/2017 return data directly from CSMAR. WRDS is expected to include such data sets in the near future.

To maintain consistency, CSMAR adjusts operating income retroactively as if operating income includes investment income throughout the database. To derive core earnings throughout the years, we subtract investment income from operating income recorded in the CSMAR database.

We focus on pre-tax total profit to avoid any complications caused by tax factors. This approach is consistent with listing investment income in the income statement on a pre-tax basis.

As core earnings tend to be more persistent than investment income, we expect the coefficient on core earnings to be greater than that on investment income. A larger coefficient on investment income in the pre-regulation period turns out to be somewhat surprising. While core earnings closely follow a normal distribution, investment income is right-skewed with many observations of zero value. To address the concern of extreme values, we substitute actual values of CORE, INVEST, and OTHER with their percentile rankings converted to a [0, 1] scale. Untabulated analysis shows that the coefficients of CORE, INVEST, and OTHER are 0.260, 0.150, and 0.029, respectively, a monotonic pattern, consistent with our priors.

The regressions in Table 4 are Fama-MacBeth regressions, whereas the Mishkin test in Table 6 is a pooled regression. While most results between these two tables are consistent with each other (all variables in the pre-regulation period and INVEST and OTHER in the post-regulation period), the results on CORE in the post-regulation period are not consistent between these two tables. Table 6 shows that the market significantly over-weights CORE in the post-regulation period, whereas Table 4 shows that the market over-weights CORE but the overweighting is statistically insignificant.

Studies have examined some specific items, such as earnings from debt restructuring (He et al. 2012). We examine the summary measure of non-operating activities as a broader coverage of earnings management activities and supplement the findings about the regime shift in 2006.

We do not rule out the possibility that firms manage investment income in the quarter after observing the same-quarter core earnings. We believe the lead-lag relationship introduced here helps to address the causality issue that firms manage investment income in response to the level of core earnings.

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Title: Does financial reporting above or below operating income matter to firms and investors? The case of investment income in China
Authors: Mei Luo
Shuai Shao
Frank Zhang
Publication date: 09-07-2018
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 4/2018
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-018-9455-1

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