Earnings Management in Dynamic Settings

Abstract

This paper develops a simple model to examine the dynamic relationship between earnings management and accounting regulations. In this model, current accrual-based earnings management affects the tightness of future regulations and managers rationally choose the levels of both accrual-based and real earnings management. We compare this dynamic model with the static one where the tightness of regulations is not affected by past levels of accrual-based earnings management and is, thus, constant over time. Our analysis reveals that accounting regulations directly affect relative costs of accrual-based and real earnings management in both static and dynamic settings, which is consistent with prior empirical and analytical studies. More importantly, we find that the impact of the change in manager's time horizon may be different for static and dynamic models of regulations. We also find that the initial state of the economy affects how managers adjust the levels of earnings management over time.