Loss Aversion and the Zero-Earnings Discontinuity

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