Legal insider trading, CEO's incentives, and quality of earnings

The recent accounting scandals brought into light the failure of corporate governance mechanisms to curbing earnings management. This study focuses on the insiders who design the managers' compensation contracts. The contract designers are seen as lacking the financial expertise to correctly uncover the true outcome. However by virtue of their knowledge of the contract details, they can discern the likelihood that the firm's public report is not truthful. Modeling the firm as a principalagent contract, we show that insiders induce earnings management and make trading gains by designing suboptimal incentives. Given that our results are driven largely by the lack of these directors' financial expertise, our study has the policy implication that inclusion of financial experts in compensation committees can contribute to transparencies under the current insider trading rules in place.