Evidence of the Relation between Accounting for Equity Investments and Equity Valuation

Abstract

Income recognition events for equity investments reflect an investor's ability to influence the activities of an investee and therefore the timing of income realization to the investor. Investor firms with passive equity investments recognize investment income when investee dividends are declared, whereas investors with nonpassive equity investments recognize investment income as investee income is earned. To determine whether market participants associate investor income realization with the income recognition events, investor and investee security return correlations are examined around investee dividend and earnings announcements. The correlations suggest an association between passive and nonpassive investor valuation and investee dividend and earnings announcements that corresponds to the accounting income recognition procedures for equity investments. Analysis of the relative timing of investor and investee announcements indicates that the results are not due to a naive fixation on accounting revenue recognition events. Rather, the results suggest differences in the substance of the investor-investee relation between passive and nonpassive investments. The results are robust to alternative specifications and controls for relative investment size and industry affiliation.