Earnings Management and Dynamic Incentives

41 Pages Posted: 18 Aug 2014 Last revised: 2 Nov 2015

See all articles by Sunil Dutta

Sunil Dutta

University of California, Berkeley - Haas School of Business

Qintao Fan

University of Oregon, Lundquist School of Business

Date Written: November 1, 2015

Abstract

This paper investigates the impact of earnings management on incentives and welfare in a two-period agency setting. Managerial performance measures are positively correlated because of a time-invariant productivity component that aff ects earnings in both periods. The firm and the manager learn about this permanent earnings component over time and cannot commit not to revise the contract terms in light of updated information. While learning over time reduces uncertainty, its strengthening eff ect on the second period incentive rate is o set by the need to mitigate earnings inflation. We fi nd that when the uncertainty about permanent earnings is large enough, allowing some earnings management can enhance welfare because the efficiency gain from the manager's reduced risk exposure can outweigh the deadweight cost of earnings management. We also consider a career concern setting in which the permanent component of earnings relates to managerial ability. Contrary to Gibbons and Murphy (1992), we fi nd that incentive rates and productive eff orts can decline over the manager's tenure.

Keywords: Earnings Management; Renegotiation; Permanent Earnings; Career Concerns

Suggested Citation

Dutta, Sunil and Fan, Qintao, Earnings Management and Dynamic Incentives (November 1, 2015). AAA 2015 Management Accounting Section (MAS) Meeting, Available at SSRN: https://ssrn.com/abstract=2482133 or http://dx.doi.org/10.2139/ssrn.2482133

Sunil Dutta

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
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Berkeley, CA 94720
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510-643-1412 (Fax)

Qintao Fan (Contact Author)

University of Oregon, Lundquist School of Business ( email )

Lillis Business Complex
#374
Eugene, OR 97403
United States
5143464865 (Phone)

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