The Information Content of Losses: Shareholder Liquidation Option and Earnings Reversals

Abstract

Using Australian data this paper investigates the information content of losses. We are motivated by the possibility that losses and profits have different associations with share returns because losses are not expected to be permanent. Consistent with the evidence in Hayn (1995), our findings show that share returns do have a lower association with losses. In particular, we extend Hayn (1995) and focus on losses made by financially healthy firms where we provide an explanation for the low ERC for these losses. We are able to find supporting evidence that the low ERC is due to shareholders' expectations of earnings reversals, thus providing further insight into the relationship between returns and losses.

Probability of loss reversal in Australia

“…Evidence from the US market is consistent with the market inefficiently assessing the probability of loss reversal (Dhaliwal et al, 2013;. Furthermore, Sin and Watts (2000) find market response to earnings to be weaker for Australian firms with more persistent loss. This evidence can be interpreted as Australian investors underreacting to persistent losses.…”

“…Therefore, assessing the probability of loss reversal is useful for investors deciding on whether to abandon the firm (Joos and Plesko, 2005). Sin and Watts (2000) examine the valuation of loss firms in Australia. They argue that, for firms that subsequently become profitable, investors are more likely to treat losses as transitory earnings.…”

“…Second, the results have implications for loss-firm valuation in Australia. While prior literature examines whether Australian investors incorporate the various accounting factors in loss-firm valuation (Sin and Watts, 2000;Wu et al, 2010), this research focuses on examining how Australian investors incorporate these accounting factors in pricing loss firms. It finds that investors' ability to interpret accounting information when pricing loss firms varies with the firm information environment.…”

Estimating Probability of Return on Loss and Its Effect on Future Abnormal Return in Iran

“…In fourth hypothesis, we showed that there is a positive and significant relationship between the probability of loss making companies being profitable in future periods and abnormal stock returns. In this regard, Sin and Watts (2000) also evaluated loss-making companies in Australia and showed that investors of loss making companies that eventually become profitable treat losses as a volatile item, since the impact of loss reversal on stock prices is visible positively and significantly. In addition, Collins and Hirbar (2002) and Chen et al (2011) and Joos and Plesko(2005) showed that the relationship between negative earnings and stock prices and performance is inverse, however, when there is a probability of loss reversal, return on equity will have incremental rate due to positive changes in the stock price.…”

“…(Joos & Plesko, 2005). Sin and Watts (2000), assessed the loss-making companies in Australia and showed that investors of loss-making companies that eventually become profitable, treat the losses as a volatile item. They found that the relationship between the loss and stock returns for those loss-making companies that have experienced high loss reversal is less important.…”