Asset Returns and Executive Compensation under Earnings Management

Executives' desire to use financial reports, especially bottom-line earnings, to pursue their own financial interests gives rise to the phenomenon of earnings management, which is defined as intentional manipulation of reported earnings by knowingly choosing accounting methods and estimates that do not accurately reflect the firm's underlying fundamentals. Empirical research documents that earnings management behavior is pervasive in the corporate world. This dissertation analyzes the economic implications of earnings management along two dimensions. The first chapter examines the effects of earnings management on executive compensation, and the second chapter investigates asset return dynamics under earnings management. The first chapter develops the optimal contract in a principal-agent model with financial reporting and moral hazard. The optimal contract is characterized both analytically and numerically, and the necessary and sufficient condition for earnings management to occur is explicitly derived. The model provides an explanation for the positive association between earnings management and incentive pay observed in both time series and cross section. The model's predictions regarding the changes of earnings management behavior and compensation structure in response to corporate governance legislations are also consistent with empirical observations. Further, this contract model serves as a micro-foundation for the asset pricing model in Chapter 2. ii The second chapter investigates stock return dynamics in an environment where executives have an incentive to maximize their compensation by artificially inflating earnings. The principal-agent model with financial reporting, developed in Chapter 1, is embedded in a Lucas asset-pricing model with periodic revelations of the underlying profitability. The return process generated from the model is consistent with a range of financial regularities observed in the return data, namely volatility clustering, asymmetric volatility, and increased idiosyncratic volatility. By incorporating earnings management in an otherwise standard asset-pricing model, this study presents a mechanism through which corporate misconduct provides a unifying cause for these stylized financial facts. In addition, the calibrated model indicates that earnings management by individual firms may not only deliver the observed features in their own stock returns, but also be powerful enough to generate market-wide patterns.

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