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We hypothesize that when confronted with a loss, investors price earnings conditional on the likelihood of the firm's return to profitability. We argue such pricing is consistent with the abandonment option hypothesis as described by Hayn (1995) and show both the pricing of losses and their characteristics vary as a function of their expected reversal. We document a more pronounced stock price response to transitory losses (i.e., losses likely to reverse), consistent with investors assessing the likelihood of exercising the abandonment option to be smaller. However, we also find evidence consistent with investors pricing persistent losses (i.e., losses not likely to reverse) negatively, a result inconsistent with the abandonment option hypothesis. Further analysis shows investors price the components of losses differently depending on the likelihood of reversal. Aggregate accruals explain the pricing of persistent losses while aggregate cash flows explain the pricing of transitory losses. The result for persistent losses relates to the presence of an increasingly larger R&D component: investors reward firms that make larger R&D outlays with larger returns. One consequence of the growing R&D component in persistent losses is that they have become a weaker indicator of the likelihood of exercising the abandonment option.

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We examine whether U.K. managers use the flexibility provided under the partial method for deferred taxes to measure unrecognized deferred taxes opportunistically. We first test whether firm-specific operational and opportunistic factors are associated with the level of unrecognized deferred taxes. The tests provide evidence certain U.K. managers opportunistically measure deferred taxes to manage leverage, consistent with arguments by commentators that deferred taxes heavily influence leverage indicators that play a prominent role in the U.K. contracting framework. Because the proper identification and measurement of both operational and opportunistic determinants of unrecognized deferred taxes influence our tests, we additionally investigate whether unrecognized taxes relate to future deferred tax reversals and future operating profitability of the firm. These tests show the components of deferred taxes predict both future deferred tax reversals and indicators of future profitability of the firm as predicted. Taken together, our results indicate that, on average, the existence of balance sheet management does not nullify the predictive power of (unrecognized) deferred taxes for future deferred tax reversals and for profitability measures. One implication of the results is that the recent U.K. standard change eliminating the partial provision method for deferred taxes potentially has reduced the usefulness of deferred tax disclosures.