Discontinuity in Earnings Report and Managerial Incentives

Abstract

This paper provides a rational explanation for earnings discontinuity in the context of the agency model. A company manager often possesses private information about the project's expected return. This information is valuable to the firm because early warning that a project is unlikely to succeed allows the firm to fire the manager and to discontinue a project with an expected loss.

When issuing a report, the manager can choose to engage in real earnings management and report higher-than-actual earnings for the current period, but as a result, the overall expected cash flow from the project will be undermined. The only way to extract the manager's private information is to offer him a generous severance payment as compensation for disclosing bad news. It is shown that any optimal contract induces overinvestment and earnings management.

Furthermore, discontinuity in earnings reports arises endogenously under most circumstances. For a linear cost of misreporting, the paper presents the closed-form solution for the optimal contract and shows that the existence of an area of discontinuity in the earnings report depends negatively on the firm size and positively on the cost of managerial effort. These results are in line with empirical studies on discontinuity in earnings and executive severance agreements.

Keywords: discontinuity in earnings report, earnings management, real earnings management, optimal contract, severance pay

JEL Classification: M41, M43, D82, G31, J33