Two accounting researchers (TR) asked the following question: Does the mere placement of a line item in the income statement matter to investors?

To answer the question, TR examined the market reaction to gains (losses) from early debt extinguishment before and after the passage of SFAS 145. Before SFAS 145 was issued in 2002, gains (losses) from early debt extinguishment were reported as extraordinary items below the line on the income statement, whereas after 2002, SFAS 145 required that such gains/losses be reported as other income and expense above the line.

In their paper, TR concluded that their principal findings demonstrated that the market response to gains (losses) from early debt extinguishment depended significantly on the accounting standard in force at the time. Before SFAS No. 145 was issued in 2002, the market did not react to these gains (losses), whereas post-SFAS No. 145 it does respond. This suggests that the market response to gains/losses is associated with their mere placement in the income statement, not with their economic content.

Required:

a. On what basis could the researchers draw the conclusion they did in the third paragraph above? 

b. Discuss the study’s findings with relation to: 

i. stock market efficiency

ii. standard setting

c. If standard setters were to change their minds and allow company managers the flexibility of deciding the placement of gains (losses) from early debt extinguishment, what would you expect to see as the managers’ reaction? Explain your prediction.