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How well do investors understand loss persistence?

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  • Kevin Ke Li

    (Rotman School of Management)

Abstract

This paper examines investors’ expectations of loss persistence. I develop a model to forecast loss firms’ future earnings based on Joos and Plesko, The Accounting Review 80: 847–870, (2005). This model produces smaller forecast errors than two random walk models and a model that assumes losses are transitory. The results suggest that investors do not fully distinguish the differences in loss persistence captured by the model and instead appear to assume that all losses are transitory. Consequently, investors are surprised by future announcements of negative earnings for firms with predicted persistent losses, and these firms experience significantly negative abnormal returns over the following four quarters. Additional results indicate that the future negative returns of firms with predicted persistent losses are smaller in magnitude when these firms are followed by analysts. The results are robust to controls for various price anomalies and are not driven by short sale constraints.

Suggested Citation

  • Kevin Ke Li, 2011. "How well do investors understand loss persistence?," Review of Accounting Studies, Springer, vol. 16(3), pages 630-667, September.
    • Handle: RePEc:spr:reaccs:v:16:y:2011:i:3:d:10.1007_s11142-011-9157-4
    DOI: 10.1007/s11142-011-9157-4
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    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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