Is More Monitoring Better?

Abstract:     
This paper studies the interaction between corporate governance mechanisms chosen by the Board of Directors (BoD) and earnings management behaviors of the manager of a firm, as well as how the interaction affects shareholders' value. We develop a dynamic agency model with renegotiation between the BoD and the manager. Both the degree of earnings manipulation and the BoD's two-task monitoring activities (i.e., productive and financial monitoring) are endogenously derived. The resulting equilibrium shows why and how the manager shifts earnings over time. Even though the BoD anticipates the earnings manipulation, the BoD chooses to not allocate his effort to financial monitoring if the manipulation is costless to the manager. However, the BoD chooses to allocate some or all of his effort to financial monitoring if the manipulation is costly to the manager. The mixed results imply that, while more board monitoring limits earnings manipulation, it may not always beneficial to shareholders. This model also offers implications concerning the direct and indirect effects of various kinds of changes in corporate governance measures mandated by governments in many countries in recent years.

Keywords: corporate governance, board of directors, earnings management, monitor, dynamic agency, renegotiation, Sarbanes-Oxley Act

JEL Classifications: M41, G38, D80

Working Paper Series