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Loss aversion and the zero-earnings discontinuity

Leonidas de la Rosa and Nikolaj Kirkeby Niebuhr
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Nikolaj Kirkeby Niebuhr: Department of Economics and Business Economics, Aarhus University

Economics Working Papers from Department of Economics and Business Economics, Aarhus University

Abstract: Prior literature suggests that the zero-earnings discontinuity is caused by earnings management. This makes sense if investors are naïve. We test for the possibility of investor naïveté and find that they are aware of firms performing earnings management around zero reported earnings and that there is no ob-vious 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. Assuming our model gen-erates the observed data, a loss-aversion coefficient of 1.2595 matches the discontinuity below zero reported earnings observed in the data simulated from the model and in the actual data. This loss-aversion coefficient is consistent with Tversky and Kahneman (1992), who find that losses are weighted roughly twice as heavily as gains.

Keywords: Discontinuity; Loss Aversion; Reporting; Signaling (search for similar items in EconPapers)
JEL-codes: C70 D91 G41 M41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-upt
Date: 2019-08-12
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Persistent link: https://EconPapers.repec.org/RePEc:aah:aarhec:2019-09

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