Abstract - Earnings Manipulation and Incentives in Firms

We study the effect of earnings manipulation on incentives within the corporate
hierarchy. Division managers have to be compensated for not blowing the whistle when top managers manipulate earnings. We show that it is easier for division managers to prove top management’s manipulations when the performance of their own division is low. Earnings manipulation therefore undermines middle managers’ incentives to exert effort and destroys value. We show that earnings manipulation is more likely to occur in flatter hierarchies. We also discuss implications of our model as regards the Sarbanes Oxley Act regulations on auditing and the protection of whistle-blowers.

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