The effect of directors’ equity incentives on earnings management

This study examines the effect of allowing directors to trade in a firm’s shares on the likelihood of earnings management, on the firm’s value, and on the stock price. We study these issues in a stylized principal-agent game wherein the directors induce earnings management by allowing managers flexi...

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Bibliographic Details
Published inJournal of accounting and public policy Vol. 25; no. 4; pp. 359 - 389
Main Authors Ronen, Joshua, Tzur, Joseph, Yaari, Varda (Lewinstein)
Format Journal Article
LanguageEnglish
Published New York Elsevier Inc 01.07.2006
Elsevier
Elsevier Sequoia S.A
SeriesJournal of Accounting and Public Policy
Subjects
Boards of directors
Compensation
Corporate governance
Earnings management
Effects
Governance
Insider trading
Principal-agent
Studies
United States > US
Insider trading
Principal-agent
Governance
Compensation
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Summary:This study examines the effect of allowing directors to trade in a firm’s shares on the likelihood of earnings management, on the firm’s value, and on the stock price. We study these issues in a stylized principal-agent game wherein the directors induce earnings management by allowing managers flexibility in reporting. In contrast to Stein [Stein, J.C., 1989. Efficient capital markets, inefficient firms: A model of myopic corporate behavior. Quarterly Journal of Economics 104 (4), 655–669], we show that earnings management distorts the stock price because the market cannot undo the bias in the accounting report. Furthermore, it reduces the firm’s value because of its unfavorable effect on the manager’s effort. These results stand in contrast to the previous literature on insider trading and have important policy implications. They support the OECD’s 2004 recommendation to prohibit insider trading.
ISSN:0278-4254
1873-2070
DOI:10.1016/j.jaccpubpol.2006.05.007