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Discontinuity in Earnings Reports and Managerial Incentives
Tatiana Fedyk,
University Of California At Berkeley
ABSTRACT. This paper addresses the question of whether discontinuity in an earnings report can arise under optimal incentive contracts when the manager has private information about the project's expected return. The manager's private information is valuable to the firm because early warning that a project is unlikely to succeed allows the firm to fire the manager and to discontinue a project with an expected loss. The only way to extract the manager's private information is to offer him a generous severance payment as compensation for disclosing bad news. It is shown that any optimal contract induces overinvestment and earnings management. Furthermore, discontinuity in an earnings report arises endogenously under most circumstances. For the linear cost of misreporting, the closed-form solution for the optimal contract is presented and it is shown that the existence of discontinuity in the earnings report depends negatively on the firm size and positively on the cost of managerial effort.
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