What is the Loss Aversion Effect?

The loss aversion effect arises when a person has a tendency to prefer avoiding a loss to acquiring an equivalent gain. For example, it is better to not lose $10 than to be given $10. In effect, there is a stronger psychological reaction to losing than to winning. This effect appears to strengthen when a person experiences a string of losses. An implication of this issue is that accountants placed in a position where their employers are reporting losses will be more likely to fraudulently enhance financial reports to help the business.

Example of the Loss Aversion Effect

As an example, Mortimer Whitlow is the controller of Perpetual Loser Corporation, which sells weight loss programs. This unfortunately-named company is required by its loan covenants to maintain a current ratio of at least 2:1, or else the lender will call its loan to Perpetual, which will drive the firm into bankruptcy. Mortimer notes that the preliminary year-end balance sheet contains a current ratio of 1.94:1. By delaying the recognition of a few small liabilities that will probably not be noticed by the auditors, Mortimer can increase the ratio to 2:1. This is a clear ethical breach, but the circumstances are placing undue pressure on Mr. Whitlow to act in this manner.