The capital market consequences associated with classifying unrealized gains and losses on available-for-sale (AFS) equity securities in GAAP net income

The Financial Accounting Standard Board (FASB) recently issued Accounting Standards Update No. 2016-01 which requires firms to report unrealized gains and losses on available-for-sale (AFS) equity securities in net income, thus reducing firms’ ability to manage or smooth earnings. Previously, these gains and losses were recorded in other comprehensive income and were not recognized in net income until the investments were sold. This paper examines the capital market consequences associated with this reporting change. Using data from U.S. public insurers, we find a significant decrease in firms’ earnings response coefficient (ERC) after the application of this new standard, and that the mechanism explaining this reduction in ERC is a decrease in earnings persistence. This result suggests that, after the reporting change, earnings less fully reflect the information investors use when revising their beliefs about firm value around earnings announcements. However, our evidence also indicates no significant changes in investor assessment of overall firm risk following the reporting change. This result suggests that investors appear to understand that the reduction in earnings persistence is not reflective of a change in firm risk. Overall, our results suggest that the classification of unrealized gains/losses on AFS equity securities into net income reduces the persistence of earnings and reduces the extent to which earnings reflect the information investors use to revise their beliefs about firm value around earnings announcements, and that investors appear to recognize that these reductions in persistence are not a reflection of firm performance becoming more volatile