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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.

Suggested Citation

  • Keith J. Crocker & Joel Slemrod, 2006. "The Economics of Earnings Manipulation and Managerial Compensation," NBER Working Papers 12645, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:12645
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    References listed on IDEAS

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    Cited by:

    1. Kwon, Illoong & Yeo, Eunjung, 2009. "Overstatement and rational market expectation," Economics Letters, Elsevier, vol. 104(1), pages 9-12, July.
    2. 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, vol. 92(C), pages 259-272.
    3. Andersson Fredrik, 2011. "Make-or-Buy Decisions and the Manipulability of Performance Measures," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 11(1), pages 1-30, December.
    4. Liu, Qi & Sun, Bo, 2015. "Managerial compensation under privately-observed hedging and earnings management," Economics Letters, Elsevier, vol. 137(C), pages 1-4.
    5. repec:eee:jebusi:v:95:y:2018:i:c:p:119-140 is not listed on IDEAS
    6. Michael Hilmer, 2014. "Bailouts, Bonuses and Bankers' Short-Termism," Working Papers tax-mpg-rps-2014-17, Max Planck Institute for Tax Law and Public Finance.
    7. Rhodes, Adrienne, 2016. "The relation between earnings-based measures in firm debt contracts and CEO pay sensitivity to earnings," Journal of Accounting and Economics, Elsevier, vol. 61(1), pages 1-22.
    8. repec:eee:reveco:v:49:y:2017:i:c:p:437-452 is not listed on IDEAS
    9. Cathy Beaudoin & Anna Cianci & George Tsakumis, 2015. "The Impact of CFOs’ Incentives and Earnings Management Ethics on their Financial Reporting Decisions: The Mediating Role of Moral Disengagement," Journal of Business Ethics, Springer, vol. 128(3), pages 505-518, May.
    10. De Chiara, Alessandro & Livio, Luca, 2017. "The threat of corruption and the optimal supervisory task," Journal of Economic Behavior & Organization, Elsevier, vol. 133(C), pages 172-186.
    11. repec:eee:jaecon:v:63:y:2017:i:2:p:253-261 is not listed on IDEAS
    12. Daniel Herold, 2017. "The Impact of Incentive Pay on Corporate Crime," MAGKS Papers on Economics 201752, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung).
    13. Robert Jones & Yan Wu, 2010. "Executive compensation, earnings management and shareholder litigation," Review of Quantitative Finance and Accounting, Springer, vol. 35(1), pages 1-20, July.
    14. repec:eee:jiaata:v:21:y:2012:i:2:p:145-155 is not listed on IDEAS
    15. Sun, Bo, 2014. "Executive compensation and earnings management under moral hazard," Journal of Economic Dynamics and Control, Elsevier, vol. 41(C), pages 276-290.
    16. Subrata Chakrabarty, 2015. "The Influence of Unrelated and Related Diversification on Fraudulent Reporting," Journal of Business Ethics, Springer, vol. 131(4), pages 815-832, November.
    17. Andergassen, Rainer, 2010. "Product market competition, incentives and fraudulent behavior," Economics Letters, Elsevier, vol. 107(2), pages 201-204, May.
    18. Laszlo Goerke, 2008. "Tax Overpayments, Tax Evasion, and Book-Tax Differences," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 10(4), pages 643-671, August.
    19. Josef Schroth, 2015. "Managerial Compensation Duration and Stock Price Manipulation," Staff Working Papers 15-25, Bank of Canada.
    20. Anne Beyer & Ilan Guttman & Iván Marinovic, 2014. "Optimal Contracts with Performance Manipulation," Journal of Accounting Research, Wiley Blackwell, vol. 52(4), pages 817-847, September.
    21. Andergassen, Rainer, 2016. "Managerial compensation, product market competition and fraud," International Review of Economics & Finance, Elsevier, vol. 45(C), pages 1-15.
    22. repec:oup:rcorpf:v:4:y:2015:i:1:p:108-154. is not listed on IDEAS
    23. repec:eee:reveco:v:49:y:2017:i:c:p:190-210 is not listed on IDEAS
    24. repec:eee:jaecon:v:64:y:2017:i:1:p:1-14 is not listed on IDEAS
    25. Ralph-C. Bayer, 2017. "The Double Dividend of Relative Auditing – Theory and Experiments on Corporate Tax Enforcement," School of Economics Working Papers 2017-14, University of Adelaide, School of Economics.

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    JEL classification:

    • A12 - General Economics and Teaching - - General Economics - - - Relation of Economics to Other Disciplines

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