Misreporting, Optimal Incentives, and Auditing

• Author: Gino Loyola,Yolanda Portilla
• Published date: 01 June 2018
• Date: 01 June 2018
• DOI: http://doi.org/10.1111/irfi.12128

Misreporting, Optimal Incentives,

and Auditing

GINO LOYOLA

†

AND YOLANDA PORTILLA

‡

†

Department of Management Control, University of Chile, Santiago, Chile and

‡

School of Economics and Business, Universidad Nacional Andrés Bello,

Santiago, Chile

ABSTRACT

We propose a model that rationalizes the adoption of a misreporting system

allowing managerial earning manipulation. A key element of our approach is

the possibility of a tacit collusion between the board and the top management

at the expense of shareholders and outside investors. Our framework predicts

that the adoption of a misreporting system is mainly related to (i) the cost to

the management of implementing such a system, (ii) the level of incentives

and punishment the board faces, and (iii) the degree of independence/

integrity of external auditors.

JEL Codes: D86; G34; J33; M41; M42

I. INTRODUCTION

This article proposes an optimal contracting model between the board of

directors and the top management that analyzes the conditions under which a

company adopts an either truthful or misreporting system. Whereas under the

first system the true level of profits is always disclosed, under the second the

management overstates profits.

We show that the class of reporting system finally implemented mainly

depends on a cost–benefit analysis, which includes (i) the managerial cost of

implementing a misreporting system, (ii) the detecting probability of the

external auditing technology, (iii) the level of fines the board must pay if a

misreporting system is detected by auditors, and (iv) the pay-performance

sensitivity of the board’s compensation scheme.

There is a large body of previous literature modeling earning management

behavior (Lacker and Weinberg 1989; Evans and Sridhar 1996; Goldman and

Slezak 2006; Povel et al. 2007; Baglioni and Colombo 2011; Andergassen,

2010, 2016). However, this literature differs from our setup in that it does

not consider the possibility that the board incentivizes the manager to

manipulate earnings, as most of these works assume that truthful reporting

is always superior to falsification. In contrast, we identify here conditions

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12128

International Review of Finance, 18:2, 2018: pp. 287–295

DOI:10.1111/irfi .12128

© 2017 International Review of Finance Ltd. 2017