A Rational Expectations Theory of the Kink in Earnings Reports

42 Pages Posted: 1 Nov 2004

See all articles by Ilan Guttman

Ilan Guttman

Leonard N. Stern School of Business, New York University; New York University - Stern Scholl of business

Ohad Kadan

Washington University in St. Louis - John M. Olin Business School

Eugene Kandel

Hebrew University of Jerusalem - Department of Economics; Centre for Economic Policy Research (CEPR)

Date Written: September 2004

Abstract

Empirical evidence suggests that the distribution of earnings reports exhibits kinks. Managers manage earnings as if to meet exogenously pre-specified targets, such as avoiding losses and avoiding a decrease in earnings. This is puzzling because the compensation to managers at these pre-specified targets seems to be smooth. We propose a game theoretic model explaining this phenomenon. In our model, investors form expectations of such a manipulative behavior by the manager. Given these expectations, the best response of the manager is to fulfill the investors' expectations, resulting in a discontinuity in the distribution of earnings reports. Our model generates several new empirical predictions regarding the existence of the kink, its size and its location relative to the distribution of earnings reports.

Keywords: Managerial compensation, stock-based compensation, earnings reports, earnings management, analysts forecasts

JEL Classification: D82, G30

Suggested Citation

Guttman, Ilan and Kadan, Ohad and Kandel, Eugene, A Rational Expectations Theory of the Kink in Earnings Reports (September 2004). Available at SSRN: https://ssrn.com/abstract=613462

Ilan Guttman (Contact Author)

Leonard N. Stern School of Business, New York University ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

New York University - Stern Scholl of business ( email )

Ohad Kadan

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Eugene Kandel

Hebrew University of Jerusalem - Department of Economics ( email )

School of Business
Mount Scopus
Jerusalem 91905
Israel
+972 2 588 3137 (Phone)
+972 2 581 6071 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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