Limited Attention to Detail: How Analysts' Valuations Change Following Mandatory Option Expensing

Abstract

We show that financial analysts' valuations became less accurate and more pessimistic following a large drop in headline earnings that did not reveal new information about firm profitability. Regulation FAS 123-R required firms to begin expensing stock option compensation in the income statement, instead of disclosing costs only in financial statement footnotes. We test how this change in expense visibility affected analyst forecasts and stock recommendations. For identification, we exploit that FAS 123-R's compliance dates were staggered based on firms' fiscal year ends. Firms that began to expense options experienced larger analyst forecast errors and were one-third more likely to miss their consensus earnings forecast, relative to observationally similar firms that did not begin expensing options in the same year. Analysts also more often revised down their recommendations on these firms' stocks. As a result, affected firms experienced large drops in market value. Our results are consistent with the limited attention hypothesis that analysts and investors overvalue firms when value-relevant information is less accessible.