Equilibrium Earnings Management, Incentive Contracts, and Accounting Standards

38 Pages Posted: 28 May 2004

See all articles by Pierre Jinghong Liang

Pierre Jinghong Liang

Tepper School of Business, Carnegie Mellon University

Abstract

In this paper, we model earnings management as a consequence of the interaction among self-interested economic agents, namely the managers, the shareholders, and the regulators. In our model, a manager controls a stochastic production technology and makes periodic accounting reports about his performance; an owner chooses a compensation contract to induce desirable managerial inputs and reporting choices by the manager; and a regulatory body selects and enforces accounting standards to achieve certain social objectives. We show various economic trade-offs give rise to endogenous earnings management. Specifically, the owner may reduce agency costs by designing a compensation contract that tolerates some earnings management because such a contract allocates the compensation risk more efficiently. The earnings management activity produces accounting reports that deviate from what is prescribed by accounting standards. Given such reports, the valuation of the firm may be nonlinear and S-shaped, recognizing the manager's reporting incentives. We also explore policy implications, noting (i) the regulator may find enforcing a zero-tolerance policy - no earnings management is allowed - economically undesirable; and (ii) when selecting the optimal accounting standard, valuation concerns may conflict with stewardship concerns. We conclude earnings management is better understood in a strategic context involving various economic trade-offs.

Note: Previously titled, "The Equilibrium Reliability of Accounting Measures."

Keywords: Earnings Management, Accounting Standards, and Agency Model

JEL Classification: D82, G12, M41, M43

Suggested Citation

Liang, Pierre Jinghong, Equilibrium Earnings Management, Incentive Contracts, and Accounting Standards. Available at SSRN: https://ssrn.com/abstract=551741

Pierre Jinghong Liang (Contact Author)

Tepper School of Business, Carnegie Mellon University ( email )

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HOME PAGE: http://www2.tepper.cmu.edu/andrew/liangj

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