Earnings Manipulation and Risky Investment

Abstract

This paper develops a formal model to study earnings manipulation. It analyzes the effects of real earnings auditor quality and at-risk incentive on management's earnings manipulation decision. It shows that the management has the incentive to smooth corporate earnings even when the employment contract is linear. It also demonstrates that adding the ability to manipulate earnings to the principal-agent model drastically changes the management's attitude towards risk. The management will become risk seeking in the company's earnings when cumulative earnings management in previous periods is high even if the management has a risk-averse utility function.