DP4613 | A Rational Expectations Theory of the Kink in Earnings Reports

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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 behaviour 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.