Earnings Management and Dynamic Incentives

Abstract

This paper investigates how the possibility of earnings management affect equilibrium incentives and welfare in a two-period agency setting. Managerial performance measures are positively correlated because of a time-invariant productivity component that affects earnings in both periods. The firm and the manager learn about this permanent earnings component over time and cannot commit not to revise the contract terms in light of updated information. While learning over time reduces uncertainty, its strengthening effect on the second period incentive rate is offset by the need to mitigate earnings inflation. We find that when the uncertainty about permanent earnings is large enough, allowing some earnings management can be welfare-enhancing. We also consider a career concern setting in which the permanent component of earnings relates to managerial ability. Contrary to Gibbons and Murphy (1992), we find that incentive rates and productive efforts can decline over the manager’s tenure.