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The economics of earnings manipulation and managerial compensation

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  • The authors gratefully acknowledge the helpful suggestions provided on earlier drafts by Thomas Gresik, Arthur Snow, and seminar audiences at the Pennsylvania State University, the University of Georgia, and the University of Notre Dame. A particular debt of gratitude is owed to an anonymous referee, whose thoughtful advice and constructive criticism has greatly improved the quality of the final product.

Abstract

This article 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.

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