A Rational Expectations Theory of Kinks in Financial Reporting

45 Pages Posted: 8 Jun 2006 Last revised: 29 Dec 2009

See all articles by Ilan Guttman

Ilan Guttman

Leonard N. Stern School of Business, New York University; New York University - Stern Scholl of business

Ohad Kadan

Washington University in St. Louis - John M. Olin Business School

Eugene Kandel

Hebrew University of Jerusalem - Department of Economics; Centre for Economic Policy Research (CEPR)

Abstract

We present a rational model of earnings management. An informed manager, whose compensation is linked to the stock price, trades off the benefit of boosting the stock price by inflating the reported earnings against the costs of such manipulation. The investors rationally interpret his actions and adjust the price accordingly. When the distribution of true earnings and the compensation scheme are smooth, the conventional equilibrium in this signaling framework is also smooth and fully revealing. In this paper, we show that in the same "smooth" environment there exist equilibria in which kinks and discontinuities emerge endogenously in the distribution of reported earnings. The manager optimally chooses a partially pooling strategy, introducing endogenous noise into his report. The resulting vagueness enables the manager to reduce the average manipulation costs. The equilibrium has perfect revelation of earnings in the right and left tails of the distribution, while for intermediate earnings realizations we get one or more pools that manifest themselves as discontinuities in the distribution of reported earnings. We study the properties of these partially pooling equilibria and suggest applications to financial reporting.

Keywords: Earnings management, financial reporting, discontinuities

JEL Classification: M41, M43, J33

Suggested Citation

Guttman, Ilan and Kadan, Ohad and Kandel, Eugene, A Rational Expectations Theory of Kinks in Financial Reporting. Accounting Review, Volume 81, 2006. Available at SSRN: https://ssrn.com/abstract=906837

Ilan Guttman (Contact Author)

Leonard N. Stern School of Business, New York University ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

New York University - Stern Scholl of business ( email )

No Address Available

Ohad Kadan

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Eugene Kandel

Hebrew University of Jerusalem - Department of Economics ( email )

School of Business
Mount Scopus
Jerusalem 91905
Israel
+972 2 588 3137 (Phone)
+972 2 581 6071 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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