Earnings Management and Measurement Error

Christian Hofmann

doi:10.1007/bf03343531

Abstract

AbstractIn this paper I consider the impact of a noisy indicator regarding a manager’s manipulative behavior on optimal effort incentives and the extent of earnings management. The analysis in this paper extends a two-task, single performance measure LEN model by including a binary random variable. I show that contracting on the noisy indicator variable is not always useful. More specifically, the principal uses the indicator variable to prevent earnings management only under conditions where manipulative behavior is not excessive. Thus, under conditions of excessive earnings management, accounting adjustments that yield a more congruent overall performance measure can be more effective than an appraisal of the existence of earnings management to mitigate the earnings management problem.

Highlights

Empirical evidence indicates that earnings management is widespread in practice.1 For example, managers use accounting judgment and real transactions to influence the expectations of capital market participants and to increase their earningsbased bonus awards.2 ·3 Frequently, earnings manipulation or window dressing is the consequence of incentives based on poor performance evaluation (Merchant 1980), i.e., the manager's performance measure does not correctly reflect firm value
I find that suppressing earnings management by use of an additional indicator variable does not naturally coincide with stronger effort incentives
The analysis shows that the cost to prevent earnings management increases with a manager's effort incentives, which increase in his payoff productivity

Summary

INTRODUCTION

Empirical evidence indicates that earnings management is widespread in practice. For example, managers use accounting judgment and real transactions to influence the expectations of capital market participants and to increase their earningsbased bonus awards.2 ·3 Frequently, earnings manipulation or window dressing is the consequence of incentives based on poor performance evaluation (Merchant 1980), i.e., the manager's performance measure does not correctly reflect firm value. While contracting on the indicator variable keeps the agent from exerting manipulative effort, I find that conditions exist under which the principal optimally selects weaker effort incentives as compared to the setting without the indicator variable (Section 4-4) The key to this result is that the penalty necessary to suppress earnings management increases with effort incentives, and that the risk premium for a noisy indicator variable increases with the size for the penalty. Smith (2002) considers the impact of improving shortterm performance at the expense of a non-financial, long-term measure Whereas, in both papers, earnings management is precluded only under knifeedge conditions, I show that with an indicator variable it is optimal for the principal to suppress earnings management for a wider range of parameter values.

BASIC NOTATION AND MODEL STRUCTURE

5· CONCLUDING REMARKS