Abstract
Motivated by the disconnect between survey evidence documenting that executives prioritize implicit contracting (i.e., labor market-based career concerns) when making earnings management decisions (Graham et al., 2005) and the extant literature’s focus on explicit contracting to explain earnings manipulation, we analytically examine the role of managerial career concerns in earnings management. Building on Holmstrom (1982, 1999), we present a career concerns-based earnings management model that incorporates the unique reversing nature of earnings management. A key insight derived from the model is that whether the predictions of a traditional career concerns model prevail, which is to say that managers engage in more income-increasing behavior in their early years, critically depends upon the reversal characteristics of the earnings management vehicle chosen.
Highlights
Top executives of US publicly traded firms often face intense incentives to manage earnings.1 Most of the extant academic literature links the incentives for earnings management, directly or indirectly, to explicit contracts such as executive cash bonus maximization contracts (Healy, 1985) or the avoidance of debt covenant violations
This is surprising, especially given the survey evidence of Graham et al (2005), which documents that more than three quarters of responding executives consider upward mobility in the labor market to be more important than short-run current compensation benefits in influencing their earnings management decisions.4. Our study addresses this apparent disconnect between the importance placed upon implicit contracts by executives and the extant literature’s focus on explicit contracts by developing an analytical model of earnings management that builds upon the seminal career concerns work of Holmstrom (1982, 1999)
Whereas in the traditional career concerns setting managers are expected to exert themselves relatively more in their early years in order to influence the labor market’s assessment of their quality, our model predicts that managers will engage in less income-increasing earnings management in their early career stage under certain conditions related to the value-destructive properties of particular types of earnings management
Summary
Top executives of US publicly traded firms often face intense incentives to manage earnings. Most of the extant academic literature links the incentives for earnings management, directly or indirectly, to explicit contracts such as executive cash bonus maximization contracts (Healy, 1985) or the avoidance of debt covenant violations While such explicit contracting-based incentives undoubtedly play an important role, the literature has been almost silent about the effects of implicit contracts and incentives over earnings management.3 This is surprising, especially given the survey evidence of Graham et al (2005), which documents that more than three quarters of responding executives consider upward mobility in the labor market (i.e., an implicit career incentive) to be more important than short-run current compensation benefits in influencing their earnings management decisions.. Empirical evidence supports the notion that, as deviations from optimal behavior, real earnings manipulations have first-order cash flow consequences and are associated with longer-term value destruction to the firm (see, e.g., Li, 2010 and Vorst, 2015) Our model incorporates these characteristic differences between accrual-based and real earnings management, leading to predictions that differ from the standard career concerns model depending upon the earnings management vehicle chosen.
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