Earnings Metrics, Information Processing, and Price Efficiency in Laboratory Markets

Abstract

An enduring issue in financial reporting is whether and how salient summary measures of firm performance (“earnings metrics”) affect market price efficiency. In laboratory markets, we test the effects of salient earnings metrics, which vary in how they combine persistent and transitory elements, on investor information search, beliefs about value, offers to trade, and market price efficiency. We find that including transitory elements in salient earnings metrics causes traders to search unnecessarily for further information about these elements and to overestimate their effect on fundamental value relative to a rational benchmark. In contrast, separately displaying persistent elements in earnings increases the accuracy of traders’ value estimates. Prices generally reflect traders’ beliefs about value, and prices are most efficient when transitory elements are excluded from earnings metrics entirely. Our study contributes to research on salience effects in financial reporting by showing that including transitory elements in salient earnings metrics causes inefficient information search and biased beliefs about value that can aggregate to affect market prices. We also contribute to research in experimental markets by showing that redundant disclosure is not always beneficial; redundant disclosure of transitory earnings elements, in particular, appears to have negative consequences for investor behavior and market efficiency.

Is Tax Return Information Useful to Equity Investors?

“…When TE does not perfectly match cash tax payments to book income, then the coefficient on TE will be smaller (i.e., greater than -1); this would be the case if tax expense contains noise (e.g., the manipulation of tax accounts to manage earnings) or if certain tax accruals are not expected to translate into cash tax payments (e.g., uncertain tax positions that are not expected to be overturned by a tax audit). On the other hand, the coefficient on TE may be larger (i.e., less than -1) if TE contains information about future cash tax payments, such as a tax expense surprise that is expected to persist into future periods (Ohlson 1999;Elliott et al 2015).…”

“…If taxable income contains measurement error in capturing firm performance or contains less information about firm performance incremental to book income, then the coefficient on TE will be smaller (i.e., less positive or more negative). On the other hand, the coefficient on TE may be larger (i.e., more positive or less negative) if TE contains information about future firm performance, such as a firm performance surprise that is expected to persist into future periods (Ohlson 1999;Elliott et al 2015).…”

“…Since it can be very difficult to piece together a firm's tax position from the financial statements (Hanlon 2003;McGill and Outslay 2004) and can require difficult and complex calculations (Graham 1996), providing investors with the same tax information that is currently included in the financial statements in an easier-to-process manner (i.e., saliently and without requiring significant computations), such as by directly giving them the tax return, may be beneficial. Prior literature has shown that simply changing the presentation of information to make it easier to process can enhance information acquisition (Hirst and Hopkins 1998) and improve investor weighting of information (Maines and McDaniel 2000), leading to greater market efficiency (Dietrich et al 2001;Elliott et al 2015). This effect occurs because investors have limited attention, and thus are less likely to incorporate information into their judgments when it is more difficult to process (Bloomfield 2002;Hirshleifer and Teoh 2003).…”

“…Additionally, former Treasury Secretary Paul O'Neill has said that making tax returns public could subject companies to "misinformed, inexpert analysis"(Lenter et al 2003, 806). Since easier processing of less value-relevant information can lead investors to inefficiently overweight the information(Elliott et al 2015), providing non-value-relevant TRI to equity investors could result in less market efficiency due to investor overweighting of this information.23 In addition to providing more information than financial statements on these items, tax returns have the additional benefit of being highly quantitative (i.e., versus potentially-qualitative financial statement disclosures), which can enhance information flow and user processing(Lundholm et al 2014; Hutchens 2015).…”

Limited Attention: Implications for Financial Reporting

“…For example, Drake et al (2017) shows that non-professional coverage of corporate news may decrease the price responsiveness to the news. In an experimental study, Elliott et al (2015) designs a setting in which participants trade based on disclosure of earnings. The authors find that price is most efficient when the transitory components of earnings are excluded from the earnings metrics.…”