Salient Earnings Metrics, Motivated Reasoning and Market Efficiency

• In Event: Earnings Properties and Saliency

Abstract

We examine the effect of displaying salient, yet redundant, summary measures of firm performance, or “earnings metrics,” on market price efficiency in laboratory markets. Specifically, holding constant the availability of underlying information, we consider the salient display of earnings metrics that (1) aggregate persistent and transitory elements, (2) disaggregate persistent and transitory elements, and (3) include only persistent elements (and exclude transitory elements); we also consider a control condition that displays no earnings metric. Consistent with previous research on bounded rationality, we find that saliently displaying earnings metrics that disaggregate persistent and transitory elements improves market efficiency compared to a metric that aggregates these elements or no earnings metric. However, displaying disaggregated earnings metrics harms market efficiency compared to a metric that includes persistent elements alone. In other words, we find that excluding transitory elements from earnings metrics yields the greatest efficiency benefits, even though traders need this information to accurately predict fundamental value. Further, we find that market efficiency is harmed by the salient display of a more transparent, disaggregated earnings metric because buyers in this condition “misunderstand” persistence when transitory elements increase (i.e., when they are consistent with their goal of making money on their investment), by upwardly biasing their bids and spending less time examining underlying information. Our study cautions regulators who seek to “increase the prominence of items reported in other comprehensive income” (FASB [2011], 1) as the increase in transparency that is likely obtained by more saliently displaying transitory along with persistent earnings elements may come with a tradeoff in terms of market efficiency.

Authors

• Wynter Brooke Elliott, University of Illinois at Urbana–Champaign

• Jessen L. Hobson, University of Illinois at Urbana–Champaign

• Brian Joseph White, The University of Texas at Austin