Nominal Rigidities, Earnings Manipulation, and Securities Regulation

Abstract

This paper documents a new fact: firms with sticky-output prices are more likely than firms with flexible prices to misreport earnings when securities regulation is lenient, and their misreporting drops significantly once regulation becomes stringent. Firms with sticky prices also face improved credit-market conditions following stricter regulations. To explore the theoretical underpinnings behind these findings, we build a model of earnings manipulation with endogenous manipulation costs, where product prices signal firms' private information about profits and mimicking firms must set a price identical to that set by mimicked firms. The model predicts that managers' incentives to manipulate earnings increase with price stickiness, as do the firms' borrowing costs, whereas regulatory punishment reduces such incentives. Our study suggests firms' stickiness in product pricing facilitates insiders' self-interested behavior, imposing agency costs on firms.

Keywords: JEL Classification: E12, E44, G28, G32, G33