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

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.     

Taxation,imperfect competition,and discontinuities

Most work on taxation assumes that market adjustments to taxation will be small and continuous and so analyzes the effects of taxation using standard marginal methods. However, the world often changes in large and discontinuous ways. This paper looks at the effects of taxation when discontinuities in market adjustments are allowed because market structure is determined endogenously by the discrete entry and exit decisions of firms. The results indicate that the potential for discontinuities generates tax effects that are considerably different from those that emerge when adjustments are small and continuous. With discontinuities, taxes can have large and discrete effects, for example, by increasing prices far in excess of the tax itself or by changing utility in a highly nonmarginal way. Of more significance, with discontinuities taxes can actually increase welfare even when they lessen competition and raise prices. Taxes can also have markedly different effects on the income and welfare of different groups. Consumers are always made worse off by a tax, but a tax may be supported by the firms in an industry if the tax limits entry and thereby increases firm profits.     

Earnings Management? Erroneous Inferences Based on Earnings Frequency Distributions

A vast literature following Hayn [1995] and Burgstahler and Dichev [1997] attributed the so-called "discontinuities" in earnings distributions around zero to earnings management. Despite recent evidence that these discontinuities are likely caused by other factors, researchers and teachers continue to point to the shapes of these distributions as evidence of earnings management. We provide three sets of further evidence that these discontinuities are likely caused by factors other than earnings management: (1) we provide, as an example, a detailed analysis of the severe effects of sample selection in a recent study; this study erroneously concludes that the shape of an earnings distribution is evidence of earnings management, (2) we provide a simple explanation for the shape of the earnings distribution that is most often cited as evidence of earnings management; the relation between earnings and prices differs with the magnitude and the sign of earnings, and (3) we provide further examples that support the main point of our paper; evidence beyond the mere shape of a distribution must be brought to bear before researchers can draw conclusions regarding the presence/absence of earnings management.     

Critical and strategic factors for scenario development and discontinuity tracing

This paper discusses the contribution of critical and strategic factors to three open questions in scenario development and futures research: discontinuities, multi-dimensionality in scenarios, and communicating and learning about change and complexity. It is observed that discontinuities do not necessarily take the form of rapid breaks within one single field. The term “hidden discontinuity” is employed to describe developments that arise from (a) the combination of several trends that may each be unspectacular or (b) gradual, long-term processes. The second open question concerns the tension between the need to work in multi-dimensional spaces while also keeping complexity manageable and selecting “representative” futures. The third problem concerns difficulties to recognize, accept and communicate the above two effects (a) and (b). After discussing these questions, two examples of recent scenario studies are used to illustrate how the identification of critical factors can contribute to identifying meaningful discontinuities and meaningful subsets within the multidimensional space of possibilities, and to learning about the scale and scope dimensions of long-term change processes and the impact of the interplay between different fields.     

Comments on the valuation of derivative assets

This paper presents an alternative approach to derive the Breeden-Litzenberger valuation formula, which expresses the price of an arbitrary derivative security in terms of call options' prices. This valuation formula follows from the observation that a continuous derivative security can be replicated by a portfolio including a bond and call options with all possible exercise prices. Discrete terms are added to the original Breeden-Litzenberger formula to reflect possible discontinuities of the call option price's derivative with respect to the exercise price. These discontinuities are subsequently shown to correspond to mass points of the probability distribution of the stock price. Several applications of the Breeden-Litzenberger valuation formula are demonstrated.     

Are hedge fund managers systematically misreporting? Or not?

A discontinuity, or kink, at zero in the hedge fund net return distribution has been interpreted as evidence of managers manipulating returns to avoid showing small losses. Instead, we propose alternative explanations for this phenomenon. In particular, we show that incentive fees can mechanistically create a kink in the net return distribution. This mechanism accounts for almost the entire kink observed in the large, liquid Long-Short Equity style. Furthermore, we show that asset illiquidity and the bounding of yields at zero can generate distribution discontinuities as well. Therefore, we conclude that the observed hedge fund return discontinuities are not direct proof of manipulation.     

Earnings management and accounting income aggregation

Quarterly earnings allow aggregation into annual earnings in four different ways. Fiscal year earnings is one measure of annual earnings, the others being earnings for annual periods ending at interim quarter-ends. We investigate earnings management in fiscal year earnings relative to these alternative measures of firms’ annual earnings. We confirm prior findings in Burgstahler and Dichev (1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99–126) of discontinuities around zero and prior year earnings in histograms of earnings. Subsequent research questions whether these discontinuities are evidence of earnings management. Using histograms of our alternative annual earnings measures, we offer evidence suggesting earnings management is responsible for the discontinuities.     

Earnings Management in Australian Corporations

This article surveys the literature examining the earnings management behaviour of Australian corporations. While numerous motivations for earnings management are proposed in this literature, current period CEO turnover is the only phenomenon for which there is consistent empirical support. A number of studies report discontinuities in the distribution of earnings around benchmarks such as the zero profit level. However, there is no evidence that these discontinuities are associated with abnormal accrual behaviour. Evidence regarding the ability of various governance mechanisms to constrain earnings management is also mixed. While several studies report a negative relation between auditor size and earnings management, no Australian studies attempt to control for the likely endogenous nature of this relationship. Papers report that board independence and audit committee independence constrain earnings management in Australian corporations, although evidence is not consistent across studies. The article shows that many Australian studies of earnings management use very noisy and, in some cases, biased measures of abnormal accruals which may partly explain the inconsistency of results across studies, adding further uncertainty regarding the implications of this field of research for standard setters, investors and scholars.     

Prospecting for steel: Forecasting techniques and case studies

Futures research in the British Steel Corporation is carried out by its Forward Technology Unit. In this article the style that the Unit has developed is described, demonstrating how, provided it is carefully focused and blended with a good proportion of inventiveness, forecasting can be of particular value to this very capital-intensive industry. Use of methodologies is illustrated in three case studies and a new approach to forecasting discontinuities is suggested.     

The determinants of innovation: Market demand,technology, and the response to social problems

Market demand is not necessarily the sole, or even the principal, determinant of the scale and direction of inventive and innovative activity—still less of scientific activity. Recent research shows that the influence of the market may vary greatly, with cyclic changes (birth, growth, and decline) and discontinuities in industry. In addition, chance plays a far greater role in competitive survival and growth than it is comfortable to admit.     

STOCK PRICE PROCESSES WITH DISCONTINUOUS TIME PATHS: AN EMPIRICAL EXAMINATION

This paper discusses the statistical properties of a mixed stochastic process and conducts a thorough empirical test of the process for an extensive group of common stocks and portfolios of stocks. It is found that a homogeneous diffusion process does not adequately describe stock price fluctuations and that there are significant discontinuities in the sample paths of stock prices. This result holds for both individual stocks and portfolios of various sizes. The statistical fit of a particular mixed diffusion-jump process to sample data is also demonstrated.     

On jump processes in the foreign exchange and stock markets

This article investigates the existence of discontinuities inthe sample path of exchange rates and of a stock market index.Maximum-likelihood estimation of a mixed jump-diffusion processreveals that exchange rates exhibit systematic discontuinities,even after allowing for conditional heteroskedasticity in thediffusion process. The results are much more significant inthe foreign exchange market than in the stock market, whichsuggests differences in the structure of these markets. Finally,this jump component is shown to explain some of the empiricallyobserved mispricings in the currency options market.     

Scenario analysis in interfutures

The interfutures project used a scenario approach and focused on issues of economic development over the next 20 years. The author describes the five main stages of scenario construction and gives a summary of the six scenarios which were finally chosen. The scenarios provide possible boundaries for the world economy in the year 2000. If there are no major discontinuities, most OECD countries are likely to experience structural unemployment, protectionism, and moderate rates of growth throughout the next decade—the outlook for Third-world countries is perhaps more favourable, with growth rates generally higher than in the OECD countries.     

Growth, crisis and change in the insurance industry: a retrospect

The insurance industry currently finds itself in a revolutionary situation characterized, in part, by the impact of new direct marketing techniques, facilitated by new technologies; by corporate restructuring and the creation of international mega-corporations; and by the accelerating globalization of the industry. This article surveys recent research on insurance history with the aim of placing these developments in their long-run context. Three areas are examined for evidence of continuities and discontinuities with the past: namely, the impact of technology, the interaction between markets and organizational change, and the globalization of insurance and its relationship to economic growth.     

Universal option valuation using quadrature methods

This paper proposes and develops a novel, simple, widely applicable numerical approach for option pricing based on quadrature methods. Though in some ways similar to lattice or finite-difference schemes, it possesses exceptional accuracy and speed. Discretely monitored options are valued with only one timestep between observations, and nodes can be perfectly placed in relation to discontinuities. Convergence is improved greatly; in the extrapolated scheme, a doubling of points can reduce error by a factor of 256. Complex problems (e.g., fixed-strike lookback discrete barrier options) can be evaluated accurately and orders of magnitude faster than by existing methods.     

Telling from Discrete Data Whether the Underlying Continuous–Time Model Is a Diffusion

Can discretely sampled financial data help us decide which continuous-time models are sensible? Diffusion processes are characterized by the continuity of their sample paths. This cannot be verified from the discrete sample path: Even if the underlying path were continuous, data sampled at discrete times will always appear as a succession of jumps. Instead, I rely on the transition density to determine whether the discontinuities observed are the result of the discreteness of sampling, or rather evidence of genuine jump dynamics for the underlying continuous-time process. I then focus on the implications of this approach for option pricing models.     

Tradeoffs of foreign assistance for the weakest-link global public goods

Weakest-link global public goods, such as international security, communicable disease prevention or illegal trafficking control, create a strong incentive for rich countries to unilaterally compensate for insufficient supplies of the ‘weakest-link’ inputs by poor countries. We analyze how foreign assistance affects the donor and recipient countries, accounting for discontinuities and non-monotonicities originating from switches between structurally different equilibrium profiles. We show that voluntary foreign assistance improves provision of the public good and also welfare, but makes the donor country worse off for the medium level of income inequality. Unless inequality is large or small, a rich country may benefit from a commitment to the absence of assistance.     

Employee effort and earnings management

In this study, we examine the relationship between employee effort within the firm and earnings management, using data on working hours and discretionary accruals. With higher employee effort, we find less earnings management among U.S. firms. This result is stronger when earnings are more predictable and persists after we control for endogeneity. We also find smaller earnings discontinuities with higher employee effort. Our domestic results remain the same with a global sample. Our results suggest that earnings management enables benchmark beating with greater precision than can high employee effort alone, but also that high-effort firms may be misclassified as earnings manipulators.     

Informed and uninformed trading on the Australian dollar

Using a high-frequency data set of the spot Australian/US dollar, this study examines the distribution of quotes, spreads, and returns across the trading day. By identifying the direction of trade and the subsequent quote returns from contributing banks, the segmented nature of the market into market-makers and informed and uninformed traders is investigated. The results suggest that the economic gain possible from private information is maximised over 2 to 5 quotes and is rapidly eroded by 20 quotes (about 2 min later during busy trading times) as other new information enters the market. Also, the analysis is revealing of discontinuities in trading and the volatility of pricing across the trading day.     

Minimum wages and non-listed firm’s earnings management: Evidence from a geographic discontinuity design

We examine how and to what extent minimum wage shapes non-listed firms’ earnings information production. To identify the causality, we introduce an improved geographic information system technique to locate firms in areas that straddle the continuities of county borders and then exploit discontinuities of minimum wage at county borders. We find that firms significantly manage earnings information upward as response to increases in minimum wages, particularly for firms with financial constraints. Our findings shed light on the effects of labor policy on the information production of firms and provide policy implications to regulators concerned with the allocation efficiency of capital markets.