Earnings Manipulation and Incentives in Firms
35 Pages Posted: 30 Dec 2004
Date Written: 29 October 2005
We show that earnings manipulation destroys incentives within the corporate hierarchy. In the model, top management has incentives to over-report earnings. An insider, for instance, a division manager may gain evidence about over-reporting. We show that the division manager is more likely to have evidence, when the performance of her own division is low. Top management wants to prevent information leakage to the outside world. Hence, when the division manager threatens to blow the whistle, top management pays her a bribe. As this occurs when division output is low, the wedge between payments in high and low states of nature decreases. Earnings manipulation therefore undermines incentives to exert effort and destroys value. We show that earnings manipulation is more likely to occur in flatter hierarchies; we also discuss implications of the auditing and whistle-blowing regulations of the Sarbanes-Oxley Act.
Keywords: Agency costs, Sarbanes Oxley Act, whistle-blowing, flat hierarchies
JEL Classification: D23, G34, M41, M43, M52
Suggested Citation: Suggested Citation