Earnings Management, Time Preferences, and Long Term Decisions

Abstract

This paper studies the impact of tightening accounting standards on an impatient manager's long-term investment decisions under earnings based performance evaluation. We analyze how the manager's possibility to influence current earnings will affect his investment decision-making. We examine a two-period agency model in which the manager's efforts during the first period have short- and long-term consequences. We find that tighter accounting regulation intensifies underinvestment problems. Tighter accounting standards increase the manager's personal costs of bringing forward investment project benefits, which results in reduced incentives for the manager to supply effort on investment activities. In turn, discretion in accounting standards allows managers to anticipate the future benefits of their investment decisions in their current performance measure. This result holds valid even when compensation contracts additionally include other performance measures than regulated accounting numbers.