The Economics of Earnings Manipulation and Managerial Compensation

34 Pages Posted: 20 Nov 2006 Last revised: 22 Jul 2010

See all articles by Keith J. Crocker

Keith J. Crocker

Penn State University - Smeal College of Business

Joel B. Slemrod

University of Michigan, Stephen M. Ross School of Business; National Bureau of Economic Research (NBER)

Date Written: October 2006

Abstract

This paper examines managerial compensation in an environment where managers may take a hidden action that affects the actual earnings of the firm. When realized, these earnings constitute hidden information that is privately observed by the manager, who may expend resources to generate an inflated earnings report. We characterize the optimal managerial compensation contract in this setting, and demonstrate that contracts contingent on reported earnings cannot provide managers with the incentive both to maximize profits, and to report those profits honestly. As a result, some degree of earnings management must be tolerated as a necessary part of an efficient agreement.

Suggested Citation

Crocker, Keith J. and Slemrod, Joel B., The Economics of Earnings Manipulation and Managerial Compensation (October 2006). NBER Working Paper No. w12645. Available at SSRN: https://ssrn.com/abstract=938971

Keith J. Crocker

Penn State University - Smeal College of Business ( email )

University Park, PA 16802
United States
814-863-0664 (Phone)
814-863-0664 (Fax)

Joel B. Slemrod (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Room R5396
Ann Arbor, MI 48109-1234
United States
734-936-3914 (Phone)
734-763-4032 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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