Equilibrium Earnings Management and Managerial Compensation in a Multiperiod Agency Setting
45 Pages Posted: 26 Jul 2012 Last revised: 12 Jan 2014
Date Written: January 10, 2014
To investigate how the possibility of earnings manipulation affects managerial compensation contracts, we study a two period agency setting in which a firm's manager can engage in "window dressing" activities to manipulate reported accounting earnings. Earnings manipulation boosts the reported earnings in one period at the expense of the reported earnings in the other period. We find that the optimal pay-performance sensitivity may increase and expected managerial compensation may decrease as the manager's cost of earnings management decreases. When the manager is privately informed about the payoff of an investment project to the firm, we identify plausible conditions under which prohibiting earnings management can result in a less efficient investment decision for the firm and more rents for the manager.
Keywords: earnings management, managerial compensation, pay-performance sensitivity, information rents
JEL Classification: D82, M52
Suggested Citation: Suggested Citation