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The economics of earnings manipulation and managerial compensation

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  • Keith J. Crocker
  • Joel Slemrod

Abstract

This paper examines managerial compensation in an environment where managers may take a hidden action that affects the actual earnings of the firm. When realized, these earnings constitute hidden information that is privately observed by the manager, who may expend resources to generate an inflated earnings report. We characterize the optimal managerial compensation contract in this setting, and demonstrate that contracts contingent on reported earnings cannot provide managers with the incentive both to maximize profits, and to report those profits honestly. As a result, some degree of earnings management must be tolerated as a necessary part of an efficient agreement.

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Bibliographic Info

Article provided by RAND Corporation in its journal RAND Journal of Economics.

Volume (Year): 38 (2007)
Issue (Month): 3 (09)
Pages: 698-713

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Handle: RePEc:bla:randje:v:38:y:2007:i:3:p:698-713

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References

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  1. Gresik, Thomas A. & Nelson, Douglas R., 1994. "Incentive compatible regulation of a foreign-owned subsidiary," Journal of International Economics, Elsevier, Elsevier, vol. 36(3-4), pages 309-331, May.
  2. Lacker, J.M., 1989. "Optimal Contracts Under Costly State Falsification," Purdue University Economics Working Papers 956, Purdue University, Department of Economics.
  3. Claudio Mezzetti, 2004. "Mechanism Design with Interdependent Valuations: Efficiency," Econometrica, Econometric Society, Econometric Society, vol. 72(5), pages 1617-1626, 09.
  4. Myerson, Roger B, 1979. "Incentive Compatibility and the Bargaining Problem," Econometrica, Econometric Society, Econometric Society, vol. 47(1), pages 61-73, January.
  5. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, Econometric Society, vol. 56(5), pages 1177-90, September.
  6. Crocker, Keith J. & Slemrod, Joel, 2005. "Corporate tax evasion with agency costs," Journal of Public Economics, Elsevier, Elsevier, vol. 89(9-10), pages 1593-1610, September.
  7. Myerson, Roger B., 1982. "Optimal coordination mechanisms in generalized principal-agent problems," Journal of Mathematical Economics, Elsevier, vol. 10(1), pages 67-81, June.
  8. Keith J. Crocker & John Morgan, 1998. "Is Honesty the Best Policy? Curtailing Insurance Fraud through Optimal Incentive Contracts," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 106(2), pages 355-375, April.
  9. Steven Shavell, 1979. "Risk Sharing and Incentives in the Principal and Agent Relationship," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 10(1), pages 55-73, Spring.
  10. Mussa, Michael & Rosen, Sherwin, 1978. "Monopoly and product quality," Journal of Economic Theory, Elsevier, Elsevier, vol. 18(2), pages 301-317, August.
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  12. Alexander, Cindy R. & Cohen, Mark A., 1999. "Why do corporations become criminals? Ownership, hidden actions, and crime as an agency cost," Journal of Corporate Finance, Elsevier, Elsevier, vol. 5(1), pages 1-34, March.
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Cited by:
  1. Andersson, Fredrik, 2009. "Make-or-buy decisions and the manipulability of performance measures," Working Papers, Lund University, Department of Economics 2009:16, Lund University, Department of Economics, revised 20 Nov 2009.
  2. Laszlo Goerke, 2008. "Tax Overpayments, Tax Evasion, and Book-Tax Differences," CESifo Working Paper Series 2212, CESifo Group Munich.
  3. Andergassen, Rainer, 2010. "Product market competition, incentives and fraudulent behavior," Economics Letters, Elsevier, Elsevier, vol. 107(2), pages 201-204, May.
  4. Corgnet, Brice & Rodriguez-Lara, Ismael, 2013. "Are you a good employee or simply a good guy? Influence costs and contract design," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 92(C), pages 259-272.
  5. Sun, Bo, 2014. "Executive compensation and earnings management under moral hazard," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 41(C), pages 276-290.
  6. Robert Jones & Yan Wu, 2010. "Executive compensation, earnings management and shareholder litigation," Review of Quantitative Finance and Accounting, Springer, Springer, vol. 35(1), pages 1-20, July.

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