Adding the Noise: A Theory of Compensation-Driven Earnings Management
Empirical evidence suggests that the distribution of earnings reports is discontinuous. This is puzzling since the distribution of true earnings is likely to be continuous. We present a model that rationalizes this phenomenon. In our model, managers report their earnings to rational investors, who price the stock accordingly. We assume that misreporting is costly, but since managers’ compensation is based on the stock price, they may want to manipulate the reported earnings. The model fits into the general framework of signaling games with a continuum of types. The conventional equilibrium in this game is fully revealing (e.g. Stein 1989), and does not explain the observed discontinuity of earnings reports. We show that a partially pooling equilibrium exists in such games as well, and it generates an endogenous discontinuity in reports. By pooling reports of di?erent types, the informed manager introduces “home-made” noise into his report. The resulting vagueness enables the manager to reduce the manipulation costs. While a priori pooling looks manipulative, it is actually a way to reduce earnings management. The empirical implications of our model relate earnings management and price reaction to price- and earnings-based compensation, growth opportunities of the firm, underlying volatility, and the stringency of accounting rules. We show that this equilibrium arises due to stock-based compensation of the managers, and does not arise when they are paid based on their earnings directly. Finally, we present a general version of this model describing the behavior of biased experts in many real-life situations.
|Date of creation:||Nov 2003|
|Contact details of provider:|| Postal: Feldman Building - Givat Ram - 91904 Jerusalem|
Web page: http://www.ratio.huji.ac.il/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Riley, John G, 1979.
Econometric Society, vol. 47(2), pages 331-359, March.
- Morgan, J. & Stocken, P., 1998.
"An Analysis of Stock Recommendations,"
204, Princeton, Woodrow Wilson School - Public and International Affairs.
- Shivakumar, Lakshmanan, 2000. "Do firms mislead investors by overstating earnings before seasoned equity offerings?," Journal of Accounting and Economics, Elsevier, vol. 29(3), pages 339-371, June.
- Brian J. Hall & Jeffrey B. Liebman, 1997.
"Are CEOs Really Paid Like Bureaucrats?,"
NBER Working Papers
6213, National Bureau of Economic Research, Inc.
- Anand Mohan Goel, 2003.
"Why Do Firms Smooth Earnings?,"
The Journal of Business,
University of Chicago Press, vol. 76(1), pages 151-192, January.
- In-Koo Cho & David M. Kreps, 1987.
"Signaling Games and Stable Equilibria,"
The Quarterly Journal of Economics,
Oxford University Press, vol. 102(2), pages 179-221.
- Grossman, Sanford J & Stiglitz, Joseph E, 1980.
"On the Impossibility of Informationally Efficient Markets,"
American Economic Review,
American Economic Association, vol. 70(3), pages 393-408, June.
- Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
- François Degeorge & Jayendu Patel & Richard Zeckhauser, 1997.
"Earnings Management to Exceed Thresholds,"
- Vijay Krishna & John Morgan, 1999.
"A Model of Expertise,"
154, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics.
- Fudenberg, Drew & Tirole, Jean, 1994.
"A Theory of Income and Dividend Smoothing Based on Incumbency Rents,"
IDEI Working Papers
34, Institut d'Économie Industrielle (IDEI), Toulouse.
- Fudenberg, Drew & Tirole, Jean, 1995. "A Theory of Income and Dividend Smoothing Based on Incumbency Rents," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 75-93, February.
- Tirole, Jean & Fudenberg, Drew, 1995. "A Theory of Income and Dividend Smoothing Based on Incumbency Rents," Scholarly Articles 3160494, Harvard University Department of Economics.
- Leuz, Christian & Nanda, Dhananjay & Wysocki, Peter D., 2003. "Earnings management and investor protection: an international comparison," Journal of Financial Economics, Elsevier, vol. 69(3), pages 505-527, September.
- Burgstahler, David & Dichev, Ilia, 1997. "Earnings management to avoid earnings decreases and losses," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 99-126, December.
- Rangan, Srinivasan, 1998. "Earnings management and the performance of seasoned equity offerings," Journal of Financial Economics, Elsevier, vol. 50(1), pages 101-122, October.
- Banks, Jeffrey S. & Sobel, Joel., 1985.
"Equilibrium Selection in Signaling Games,"
565, California Institute of Technology, Division of the Humanities and Social Sciences.
- V. Crawford & J. Sobel, 2010.
"Strategic Information Transmission,"
Levine's Working Paper Archive
544, David K. Levine.
- Jeremy C. Stein, 1989. "Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior," The Quarterly Journal of Economics, Oxford University Press, vol. 104(4), pages 655-669.
- Healy, Paul M., 1985. "The effect of bonus schemes on accounting decisions," Journal of Accounting and Economics, Elsevier, vol. 7(1-3), pages 85-107, April.
- Bhattacharya, Utpal & Daouk, Hazem & Welker, Michael, 2003. "The World Price of Earnings Opacity," Working Papers 127185, Cornell University, Department of Applied Economics and Management.
When requesting a correction, please mention this item's handle: RePEc:huj:dispap:dp355. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Tomer Siedner)
If references are entirely missing, you can add them using this form.