CAN EARNINGS MANIPULATION CREATE VALUE?
CAN EARNINGS MANIPULATION CREATE VALUE?

Summary/Abstract: We consider a long-term board of directors-CEO relationship, where the firm’s performance depends on the CEO’s productive effort and where the CEO can be involved in earnings manipulation (EM). An agency-based two-period model is built and analyzed. The CEO pay includes a bonus and stock options. CEO gets stock options if the short-term earnings achieve some threshold. If EM is costly, CEO overinvests in production effort that increases the probability of getting stock options. If EM is possible, CEO production effort is closer to socially optimal level. The opportunity to manipulate earnings protects the CEO against the risk of a low payoff when the results of production are below expectations. Optimal contract trades-off social loss from EM and improved incentives for productive effort. In equilibrium some degree of EM can be optimal. We also find that EM should more frequently be observed among managers with low outside opportunities. pp. 21–40JEL codes: D86; D92; G34; J32; J33

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