Academic journal article Academy of Accounting and Financial Studies Journal

When Are Profitable Earnings Low Enough to Trigger a Liquidation Option?

Academic journal article Academy of Accounting and Financial Studies Journal

When Are Profitable Earnings Low Enough to Trigger a Liquidation Option?

Article excerpt

ABSTRACT

Our primary objective is to determine the point at which earnings become low enough to trigger a liquidation (abandonment) option during the 1998 fiscal year. Second, we investigate whether the earnings level at which the liquidation option is triggered is intertemporally stable by investigating the valuation significance of earnings and book value during two pooled time periods. Third, we seek to determine whether the decreased valuation significance in earnings is associated with a simultaneous increase in the valuation significance of book value of equity for all three time periods examined. When dividing the data into deciles according to earnings before extraordinary items, book value increases in significance and incremental explanatory power, while earnings decrease in significance and exhibit virtually no explanatory power for lower earnings deciles. Also, there appears to be a shift in the valuation reliance from earnings to book value when the ratio of earnings before extraordinary items to book value falls below 0.10 for both exchanges and for all time periods. We interpret this as evidence that sufficiently low earnings increase the reliance on book value and decrease the reliance of earnings even though bankruptcy or liquidation is not imminent and even if cross-sectional data are examined.

INTRODUCTION

Purpose and contribution

The association between a firm's market value of equity and its earnings and book value has received much attention in recent literature. For instance, Collins, Pincus, and Xie (1999) find that book value of equity serves as a value-relevant proxy for expected future normal earnings for loss firms and as a proxy for abandonment option for loss firms most like to cease operations and liquidate. Burgstahler and Dichev (1997) show that market value is a convex function of earnings (book value) holding book value (earnings) constant, while Subramanyam and Wild (1996) find that the informativeness of earnings is decreasing in the probability of termination.

The studies most directly related to the present study are the ones by Hayn (1995), by Barth, Beaver, and Landsman (1998), and by Schnusenberg and Skantz (1998). Hayn offers the abandonment hypothesis as an explanation for the weak association between negative earnings and market value of equity. Furthermore, Barth, Beaver, and Landsman use the abandonment hypothesis to explain the strong association between book value and market value for bankrupt firms. Schnusenberg and Skantz test the abandonment hypothesis for voluntarily liquidating firms and for unprofitable surviving firms.

The objective of this study is threefold. First, our primary objective is to determine the point at which earnings become low enough to trigger a liquidation (abandonment) option during the 1998 fiscal year. While previous research has successfully tested the abandonment option for bankrupt firms and for voluntarily liquidating firms and unprofitable surviving firms, Hayn (1995) argues that the liquidation option effect extends to profitable cases where earnings are low enough to make the put option attractive. Thus, the decreased valuation significance of earnings may be a function of the low earnings level in a given year as opposed to a function of the approaching liquidation of the firm. Schnusenberg and Skantz's (1998) and Collins, Pincus, and Xie's (1999) finding that the abandonment option hypothesis is equally true for nonliquidating distressed firms supports the argument that the relative valuation significance of earnings and book value could be a function of the current year's earnings. Consequently, the increasing relevance of book value (vis-a-vis earnings) could be triggered much earlier than the actual bankruptcy or liquidation and may even be independent of bankruptcy or liquidation. Obtaining a numerical estimate of the earnings level at which the liquidation option is triggered is important to standard setters and to researchers alike in order to accurately assess and utilize the relative importance of earnings and book value. …

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