A Theory on the Discontinuity in Earnings Distributions

42 Pages Posted: 27 Jan 2012

See all articles by Wei Li

Wei Li

University of Washington-Bothell; University of Illinois at Urbana-Champaign - Department of Accountancy

Date Written: January 25, 2012


This paper presents a model of financial reporting in which investors infer both pre-managed earnings and the precision of earnings from reported earnings. Over-reporting earnings has two opposing pricing effects: investors infer higher pre-managed earnings from an inflated positive earnings surprise (i.e., positive effect); however, investors also infer a lower earnings precision at the same time, leading to a lower pricing weight placed on the higher surprise (i.e., negative effect). For firms with (relatively) strongly positively autocorrelated earnings, in equilibrium, the trade-off between the two opposing effects creates a pooled report right above the prior mean of the earnings distribution and a no-reporting "hole" right below the prior mean (i.e., an earnings discontinuity consistent with empirical findings). Further, the model predicts cross-sectional variation in the earnings discontinuity phenomenon yet to be explored. In particular, the model shows and predicts: (1) no earnings discontinuity exists for firms with negatively or (relatively) weakly positively autocorrelated earnings, and (2) the earnings discontinuity is more pronounced for firms with more positively autocorrelated earnings.

Keywords: earnings discontinuity, earnings precision, earnings distribution, financial reporting

JEL Classification: M41

Suggested Citation

Li, Wei, A Theory on the Discontinuity in Earnings Distributions (January 25, 2012). Available at SSRN: https://ssrn.com/abstract=1992144 or http://dx.doi.org/10.2139/ssrn.1992144

Wei Li (Contact Author)

University of Washington-Bothell ( email )

18115 Campus Way NE
Bothell, WA 98011
United States

University of Illinois at Urbana-Champaign - Department of Accountancy ( email )

4009 BIF
515 E Gregory Drive
Champaign, IL 61820
United States
217-265-0293 (Phone)

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