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Earnings Manipilation and Incentives in Firms

  • Guido Friebel

    ()

    (University of Toulouse (EHESS and IDEI), CEPR, IZA)

  • Sergei Guriev

    ()

    (New Economic School/CEFIR and CEPR)

We show that earnings manipulation destroys incentives within the corporate hierarchy. In the model, top management has incentives to over-report earnings. An insider, for instance, a division manager may gain evidence about over-reporting. We show that the division manager is more likely to have evidence, when the performance of her own division is low. Top management wants to prevent information leakage to the outside world. Hence, when the division manager threatens to blow the whistle, top management pays her a bribe. As this occurs when division output is low, the wedge between payments in high and low states of nature decreases. Earnings manipulation therefore undermines incentives to exert effort and destroys value. We show that earnings manipulation is more likely to occur in flatter hierarchies; we also discuss implications of the auditing and whistle-blowing regulations of the Sarbanes-Oxley Act.

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Paper provided by Center for Economic and Financial Research (CEFIR) in its series Working Papers with number w0055.

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Length: 35 pages
Date of creation: Jun 2004
Date of revision: Oct 2005
Handle: RePEc:cfr:cefirw:w0055
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