Contract Disclosure, Earnings Management, and External Enforcement

50 Pages Posted: 30 Jan 2020

See all articles by Carlos Corona

Carlos Corona

Carnegie Mellon University - David A. Tepper School of Business

Tae Wook Kim

The University of Hong Kong

Date Written: January 6, 2020

Abstract

We examine the effects of mandating compensation disclosure on executive incentive contracts, earnings management, and shareholders' and social welfare. We develop a moral hazard model with multiple principal-agent pairs facing an external inspector who allocates resources across firms to uncover and penalize earnings management. Contract disclosure confers principals with a first-mover advantage, allowing them to design the contract anticipating the inspector's reaction. However, it may also exacerbate a coordination problem among principals, as they do not consider externalities on other principals caused by the effects of their contract choices on the inspector's scrutiny allocation. We find that, if the internal enforcement intensity (e.g., internal control) is relatively weak, contract disclosure may make contracts more strongly contingent on reported earnings, worsen earnings manipulation, and nevertheless increase social welfare. However, disclosure improves shareholders' welfare only if the scrutiny resources available to the inspector are not strongly constrained.

Keywords: Compensation; Contract Disclosure; Coordination; Enforcement; Inspector

JEL Classification: C72, D62, G38, M43, M46

Suggested Citation

Corona, Carlos and Kim, Tae Wook, Contract Disclosure, Earnings Management, and External Enforcement (January 6, 2020). Available at SSRN: https://ssrn.com/abstract=3515026 or http://dx.doi.org/10.2139/ssrn.3515026

Carlos Corona (Contact Author)

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

Tae Wook Kim

The University of Hong Kong ( email )

Hong Kong

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