Profits Versus Losses: Does Reporting an Accounting Loss Act as a Heuristic Trigger to Exercise the Abandonment Option and Divest Employees

Posted: 3 Jul 2007

See all articles by Matt Pinnuck

Matt Pinnuck

University of Melbourne - Department of Accounting and Business Information Systems

Anne M. Lillis

University of Melbourne

Abstract

The binary classification of firms into profits or losses represents a powerful heuristic. The literature that has examined the impact on the firm of this earnings heuristic has focused on the earnings management actions of small profit firms. The impact of this earnings heuristic on the actions of firms reporting accounting losses and the decision making effects the heuristic may have other than earnings management have not been examined. In this study we hypothesize that reporting an accounting loss acts as a heuristic trigger for firms to exercise the abandonment option and discard unproductive investments. The results are consistent with the hypothesis. We find that there is a sharp and economically significant discontinuity around zero in the level of investment in labor between small profit and small loss firms. The discontinuity is due to loss firms having a lower than expected level of investment in labor given their economic fundamentals. Further tests show that this discontinuity is due to the exercise of the abandonment option. We find that firms switching from a profit to a loss cut labor to a greater extent than other firms with similar changes in earnings that do not pass the loss threshold. Taken together the results are consistent with the accounting loss heuristic acting as a major disciplinary or incentive altering event that resolves agency problems.

Keywords: Abandonment Option, Employees, Financial Reporting Incentives, Losses, Thresholds

JEL Classification: M41, G30, G31

Suggested Citation

Pinnuck, Matthew and Lillis, Anne, Profits Versus Losses: Does Reporting an Accounting Loss Act as a Heuristic Trigger to Exercise the Abandonment Option and Divest Employees. Accounting Review, Vol. 82, No. 3, 2007. Available at SSRN: https://ssrn.com/abstract=997968

Matthew Pinnuck (Contact Author)

University of Melbourne - Department of Accounting and Business Information Systems ( email )

Victoria
Melbourne, Victoria 3010 3010
Australia

Anne Lillis

University of Melbourne ( email )

Victoria
Parkville, Victoria 3010
Australia

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