The effect of directors' equity incentives on earnings management

This study examines the effect of allowing directors to trade in a firm's shares on the likelihood of earnings management, on the firm's value, and on the stock price. We study these issues in a stylized principal-agent game wherein the directors induce earnings management by allowing managers flexibility in reporting. In contrast to Stein [Stein, J.C., 1989. Efficient capital markets, inefficient firms: A model of myopic corporate behavior. Quarterly Journal of Economics 104 (4), 655-669], we show that earnings management distorts the stock price because the market cannot undo the bias in the accounting report. Furthermore, it reduces the firm's value because of its unfavorable effect on the manager's effort. These results stand in contrast to the previous literature on insider trading and have important policy implications. They support the OECD's 2004 recommendation to prohibit insider trading.