Separating Information about Cash Flows from Information about Risk in Losses
50 Pages Posted: 7 Jan 2013 Last revised: 9 Jul 2021
Date Written: January 06, 2020
Abstract
Prior literature interprets the weak earnings response coefficient (ERC) of accounting losses as a manifestation either of lack of forward-looking information in losses or of market mispricing of losses. Based on return decomposition theory, I predict that losses contain information not only about future cash flows (i.e., cash-flow news) but also about risk (i.e., expected returns and discount-rate news). However, these informational components have offsetting valuation effects, resulting in a muted ERC. Consistent with the prediction, I show that after controlling for information about risk (mainly expected returns), the ERC of losses becomes statistically significant with more negative returns for larger losses, when returns are measured either annually or around earnings announcements. Moreover, loss firms will continue to have poor future earnings and operating cash flows and larger losses are associated with more negative analyst forecast revisions in the loss-reporting year. I also document that losses provide more negative cash-flow information when they are not due to R&D expensing, when they trigger operational curtailments, and when they are less likely to reverse to profits. Further tests confirm the robustness of my findings to considering future return drifts/reversals, alternative proxies for expected returns and discount-rate news, alternative test portfolios, and alternative model specifications. Overall, my paper provides new insights into the information content of losses.
Keywords: Accounting losses; Cash-flow news; Expected returns; Discount-rate news
JEL Classification: M41, G14, G33
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
The Effect of International Institutional Factors on Properties of Accounting Earnings
By Ray Ball, S.p. Kothari, ...
-
The Relevance of the Value Relevance Literature for Financial Accounting Standard Setting
-
Conservatism in Accounting - Part I: Explanations and Implications
-
International Differences in the Timeliness, Conservatism and Classification of Earnings
By Peter F. Pope and Martin Walker
-
By Ray Ball, Ashok Robin, ...
-
Corporate Financial Statements, a Product of the Market and Political Processes
-
Conservatism in Accounting - Part Ii: Evidence and Research Opportunities
-
Earnings Quality in U.K. Private Firms
By Ray Ball and Lakshmanan Shivakumar