When Adaptation is NOT the Option: Does the ERC Attenuate When Firms Are Less Likely to Use the Adaptation Option?

Abstract

This paper considers whether the earnings response coefficient (ERC) changes when firms are unlikely to adapt resources to other uses.  Hayn (1995) hypothesizes and provides evidence consistent with losses having less information content than gains.  Since losses are not expected to be persistent – a key determinate in the relationship between accounting earnings and returns – market participants discount those losses when formulating the expected value of the firm and instead value it based on the adaptation option, resulting in an attenuated ERC.  However, when the likelihood of the adaptation option being used is low, I predict that the ERC will not attenuate since the market will still value the firm on earnings, even though they are negative.  Using a book to market (BTM) ratio above one as my proxy for a reduced likelihood of adaptation, I am able to provide evidence consistent with my hypothesis.  This research combines the prior literature on the adaptation option, the ERC attenuation, and the BTM ratio.