In this paper I consider the impact of a noisy indicator regarding a manager’s manipulative behavior on optimal effort incentives and the extent of earnings management. The analysis in this paper extends a two-task, single performance measure LEN model by including a binary random variable. I show that contracting on the noisy indicator variable is not always useful. More specifically, the principal uses the indicator variable to prevent earnings management only under conditions where manipulative behavior is not excessive. Thus, under conditions of excessive earnings management, accounting adjustments that yield a more congruent overall performance measure can be more effective than an appraisal of the existence of earnings management to mitigate the earnings management problem.
Arya, Anil, Jonathan Glover, and Shyam Sunder (1998): Earnings Management and the Revelation Principle, Review of Accounting Studies, 3 (1–2): 7–34.
Baetge, Jörg, Thorsten Melcher, and Roland Schulz (2008): Vermeidung von Bilanzdelikten durch (Früh-)Erkennungs-methoden — Trends in der Wirtschaftsprüfung, in: G. Herde (ed.): 3. Deggendorfer Forum zur digitalen Datenanalyse, 25–54.
Christensen, Peter O. and Gerald A. Feltham (2005): Economics of Accounting: Volume II — Performance Evaluation, Springer: New York.
Dechow, Patricia M. and Douglas J. Skinner (2000): Earnings Management: Reconciling the Views of Accounting Academics, Practitioners, and Regulators, Accounting Horizons, 14 (2): 235–250.
Demski, Joel, Hans Frimor, and David Sappington (2004): Efficient Manipulation in a Repeated Setting, Journal of Accounting Research, 42 (1): 31–49.
Demski, Joel, Hans Frimor, and David E. M. Sappington (2006): Audit Error, Journal of Engineering and Technology Management, 23 (1–2): 4–17.
Datar, Srikant, Susan Cohen Kulp, and Richard A. Lambert (2001): Balancing Performance Measures, Journal of Accounting Research, 39 (1): 75–92.
Dutta, Sunil and Frank Gigler (2002): The Effect of Earnings Forecasts on Earnings Management, Journal of Accounting Research, 40 (3): 631–655.
Feltham, Gerald A. and Jim Xie (1994): Performance Measure Congruity and Diversity in Multi-task Principal/Agent Relations, Accounting Review, 69 (3): 429–453.
Gaver, Jennifer J., Kenneth M. Gaver, and Jeffrey R. Austin (1995): Additional Evidence on Bonus Plans and Income Management, Journal of Accounting and Economics, 19 (1): 3–28.
Guidry, Flora, Andrew J. Leone, and Steve Rock (1999): Earnings-based Bonus Plans and Earnings Management by Business-unit Managers, Journal of Accounting and Economics, 26 (1–3): 113–142.
Healy, Paul M. (1985): The Effect of Bonus Schemes on Accounting Decisions, Journal of Accounting and Economics, 7 (1–3): 85–107.
Healy, Paul M. and James M. Whalen (1999): A Review of the Earnings Management Literature and Its Implications for Standard Setting, Accounting Horizons, 13 (4): 365–383.
Hofmann, Christian (2004): Bilanzielle Darstellungsspielräume und langfristige Anreize, Zeitschrift für betriebswirtschaftliche Forschung, Sonderheft 51: 137–171.
Holthausen, Robert W., David F. Larcker, and Richard G. Sloan (1995): Annual Bonus Schemes and the Manipulation of Earnings, Journal of Accounting and Economics, 19 (1): 29–74.
Holmstrom, Bengt (1979): Moral Hazard and Observability, The Bell Journal of Economics, 10 (1): 74–91.
ICAEW — Institute of Chartered Accountants in England and Wales (1968): Auditors’ Reports: Forms and Qualifications — Statement of Auditing U10.
IDW-Prüfungsstandard (2000): Grundsätze ordnungsmäßiger Berichterstattung bei Abschlussprüfungen (IDW PS 450), IDW-Verlag: Düsseldorf.
Ijiri, Yuji and Robert S. Kaplan (1971): A Model for Integrating Sampling Objectives in Auditing, Journal of Accounting Research, 9 (1): 73–87.
Klein, April (2002): Audit Committee, Board of Director Characteristics, and Earnings Management, Journal of Accounting and Economics, 33 (3): 375–400.
Leuz, Christian, Dhananjay Nanda, and Peter D. Wysocki (2003): Earnings Management and Investor Protection: An International Comparison, Journal of Financial Economics, 69 (3): 505–527.
Lev, Baruch (2003): Corporate Earnings: Facts and Fiction, Journal of Economic Perspectives, 17 (2): 27–50.
Merchant, Kenneth A. (1990): The Effects of Financial Controls on Data Manipulation and Management Myopia, Accounting, Organizations and Society, 15 (4): 297–313.
Mirrlees, James A. (1974): Notes on Welfare Economics, Information, and Uncertainty, in: Michael Balch, Daniel McFadden, and Shi-Yen Wu (eds.): Essays on Economic Behavior under Uncertainty, North-Holland, Amsterdam, 243–261.
Schipper, Katherine (1989): Commentary on Earnings Management, Accounting Horizons, 3 (4): 91–102.
Smith, Michael J. (2002): Gaming Nonfinancial Performance Measures, Journal of Management Accounting Research, 14: 119–133.
Watts, Ross L. and Jerold L. Zimmerman (1978): Towards a Positive Theory of the Determination of Accounting Standards, The Accounting Review, (January) 53: 112–134.
About this article
Cite this article
Hofmann, C. Earnings Management and Measurement Error. Bus Res 1, 149–163 (2008). https://doi.org/10.1007/BF03343531
- Earnings Management
- Indicator Variable
- LEN Model
- Performance Measurement