News Management, Moral Hazard, and the Properties of Earnings, Prices, and Compensation

Abstract

I explore the theoretical properties of earnings, prices, and compensation contracts under the assumption that strategic managers are evaluated based on audited financial reports of their own making. If auditors require managers to provide verifiable evidence substantiating the contents of their financial reports, and if such evidence is produced with the agency problem in mind, then the model rationalizes market values that exceed book values, a reporting preference for immediate expensing, historical cost, or fair value depending on the cost of producing verifiable evidence, compensation contracts with floors and ceilings, an asymmetric relation between positive versus negative economic performance and earnings, a discontinuity in the earnings distribution, and an S-shaped earnings-returns relation. These phenomena are concentrated in settings where the cost of producing verifiable evidence is moderate and assets are optimally held at historical cost.