Abstract
We conduct an experiment to examine how including fair value changes in earnings influences investors’ beliefs about earnings’ predictive value. We draw on motivated reasoning theory from psychology, which suggests that investors are likely to attribute an inappropriately high level of predictive value to changes in fair value when doing so is consistent with their preferences. Consistent with this, we find that including fair value changes in earnings causes current and prospective investors to disagree about earnings’ predictive value, but only when fair value changes are positive, and thus consistent with current investors’ preferences. We also find that current investors overestimate the predictive value of earnings because they judge predictive value on the basis of earnings’ feedback value. Overall, our results suggest that including transitory fair value changes in earnings exacerbates the effect of motivated reasoning in investor judgment, creating conditions under which investors disagree about firm fundamentals.
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