Essays on Earnings Management, Investment Efficiency, and Managerial Incentives

In response to accounting scandals, market control systems (e.g. regulations related to internal control systems) have become more stringent in order to restore investors’ confidence in capital markets. Tightening control systems has triggered a fierce debate on its effect on both capital markets and the real economy. My dissertation studies how mitigating earnings management by tightening control systems can affect managerial incentives and a firm’s investment decisions. Why are CEOs rarely fired? I develop a dynamic agency model to show that costly earnings management can act as an alternative punishment for poor performance and substitute for managerial turnover. The principal can design a contract such that it is incentive compatible for the agent to engage in costly earnings management to avoid being fired when poor performance is realized. Since earnings management can impose a cost on the agent that cannot be replicated by compensation, it can effectively relax the agent’s bankruptcy constraint and, thus, the agent experiences a negative payoff when her performance is poor. Therefore, the principal can not only improve the agent’s ex ante effort incentives but also reduce the use of the threat of turnover (Incentive alignment benefit). The principal, however, may need to pay more to compensate for the cost of earnings management (Wealth transfer cost). Therefore, the trade-off between the incentive alignment benefit and the wealth transfer cost determines whether earnings management is beneficial or harmful to shareholders. In the second chapter, titled “Earnings Management, Investment, and Managerial Turnover in a Dynamic Agency Model,” I develop a model to investigate how the internal control system influences a