Management Compensation, Debt Contract, and Earnings Management Strategy

Positive accounting theory hypothesizes that certain economic and contracting variables (such as earnings-based compensation and debt contracts) provide a manager with incentives to obtain his own self-interest by managing reported earnings. A separating equilibrium at stage 1 is developed in which the manager of a good firm selects an income-increasing strategy and the manager of a bad firm selects an income-decreasing strategy. We point out that the strategic use of a debt-contract, comprised of repayments and costly distress financing, can induce the manager to reveal his firm type by an earnings management strategy at stage 1. However, in the final stage a pooling equilibrium and a separate equilibrium can be obtained at the same time. In a pooling equilibrium the managers of two types both choose an income-increasing strategy to increase their compensation. However, if the manager of the bad firm takes his reputation into consideration, then he may have an incentive to choose the income-decreasing method. We can hence derive a separate equilibrium at stage 2.