DP4850 Earnings Manipulation and Incentives in Firms

Author(s): Guido Friebel , Sergei Guriev

Publication Date: January 2005

Keyword(s): agency costs , Sarbanes Oxley Act , whistleblowing , flat hierarchies

JEL(s): D23 , G30 , M40 , M52

Programme Areas: Financial Economics , Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP4850.asp

We study the effect of earnings manipulation on incentives within the corporate hierarchy. When top management manipulates earnings, it must prevent information leakage from corporate insiders to the outside world. If an insider (e.g. a division manager) gains evidence about earnings manipulation, the threat to blow the whistle can provide them with an additional payment. We show that it is easier for division managers to prove top management’s manipulations when the performance of their own divisions is low. Earnings manipulation therefore undermines division managers’ incentives to exert effort and destroys value. We show that earnings manipulation is more likely to occur in flatter hierarchies; we also discuss implications of the auditing and whistle-blowing regulations of the Sarbanes Oxley Act.