Earnings management, incentive contracts and private information acquisition

This paper analyzes the optimal design of compensation contracts in the presence of earnings management incentives, and its interplay with investors’ information acquisition decisions. We consider a setting in which compensation contract is based on both accounting earnings and stock price when an agent engages in predictable, pernicious earnings management and stock price is endogenously determined in a Noisy Rational Expectations Equilibrium (NREE) that reflects both the public information from reported earnings and a costly, noisy signal privately acquired by investors. We show that an increase in the precision of the firm’s financial reporting system could reduce the informativeness of stock price and exacerbate the agency problem by inducing lower productive effort and higher earnings management, implying that the firm may not choose a more precise financial reporting system.