Department of Economics and Business Economics

Loss aversion and financial reporting: A possible explanation for the prevalence of discontinuities in reported earnings

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We formalize the notion, first suggested by Burgstahler and Dichev (1997), that earnings discontinuities can be caused by reference dependence. We extend the signaling model by Guttman et al. (2006) to include loss-averse investors. The presence of loss aversion causes the separating equilibrium (without discontinuities in the distribution of reported earnings) to disappear, while the partially-pooling equilibrium (exhibiting discontinuities) may prevail. This implies that the presence of loss-averse investors will cause earnings discontinuities around reference points. The prime candidates for investors’ reference points are earnings benchmarks such as zero earnings, last year’s earnings and analyst forecasts. Our model provides an explanation for why earnings discontinuities appear around earnings benchmarks.
Original languageEnglish
Article number106992
JournalJournal of Accounting and Public Policy
Volume41
Issue6
Number of pages24
DOIs
Publication statusPublished - Oct 2022

    Research areas

  • Earning Discontinuities, Loss Aversion, Reporting, Signaling

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