Working Paper: CEPR ID: DP4861
Authors: Guido Friebel; Sergei Guriev
Abstract: 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 him/her 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.
Keywords: Agency Costs; Flat Hierarchies; Sarbanes-Oxley Act; Whistleblowing
JEL Codes: D23; G30; M40; M52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Earnings manipulation by top management (M12) | Decrease in division managers' incentives to exert effort (M52) |
| Low performance in divisions + Threat of whistleblowing (D73) | Distortion of division managers' effort choices (L23) |
| Flatter hierarchies (D73) | Easier for insiders to prove manipulation (G14) |
| Top management's short-term incentives (M52) | Weaker incentives for subordinates (M54) |
| Earnings manipulation (M52) | Undermining of firm value in the long run (G32) |
| Sarbanes-Oxley Act (G38) | Reduction in earnings manipulation (G38) |
| Increased costs associated with whistleblowing + Enhanced audit scrutiny (G38) | Reduction in earnings manipulation (G38) |