Department of Economics and Business Economics

Loss aversion and the zero-earnings discontinuity

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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 inves-tors and we find that earnings management is not only rational, but in equilibrium, it is not possible for in-vestors 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 re-ported 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.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages44
Publication statusPublished - 12 Aug 2019
SeriesEconomics Working Papers

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