Loss Aversion and the Zero-Earnings Discontinuity
46 Pages Posted: 8 Dec 2019
Date Written: August 7, 2019
Abstract
Prior literature suggests that the zero-earnings discontinuity is caused by earnings management. This makes sense if investors are naíve. We test for the possibility of investor naíveté and find that they are aware of firms performing earnings management around zero reported earnings and that there is no obvious gain of reaching zero reported earnings. We extend a signaling model to include loss-averse investors and we find that earnings management is not only rational, but in equilibrium, it is not possible for investors to deduce the correct value of firms' earnings around the discontinuity. Our model could be applied to other reference points besides zero earnings, such as expected or last year's earnings
Keywords: Discontinuity, Loss Aversion, Reporting, Signaling
JEL Classification: C70, D91, G41, M41
Suggested Citation: Suggested Citation