THE INFORMATION CONTENT OF LOSSES VERSUS PROFITS AND THE DENOMINATOR EFFECT OF RISK

ABSTRACT In this paper, we investigate the information content of losses and the denominator effect of risk on earnings informativeness. The information content of losses tends to be lower than profits since the firms’ market value is better explained by liquidation value rather than earnings news. Similarly, earnings of high-risk firms tend to be less informative since risk influences the discount rate of valuation models. Through a sample of 436 Brazilian public firms (4,086 firm-year observations), the results demonstrate that risk influences how earnings from companies reporting losses and profits are perceived, showing that losses are less informative than profits for low and medium-risk firms, while this difference disappears for high-risk firms. We attribute these results to the explanation of the liquidation or abandonment option, which is corroborated by our analyses. We also tested two alternative explanations for the low informativeness of losses (accounting conservatism and hidden assets) and observed that neither of the explanations are corroborated by our findings. Our results contribute to accounting and finance literature, providing evidence that high-risk firms are valued similarly to loss firms in terms of earnings informativeness, which has not been previously demonstrated.