Can Earnings Manipulation Create Value?

A recent wave of scandals in the corporate world has raised heated debates regarding the manipulation of earnings by firms' insiders. Existing literature usually considers earnings manipulation to be a negative social phenomenon and suggests measures for its elimination. In the present paper, we argue that earnings manipulation can be a part of the equilibrium relationships between firms' insiders and outsiders. We consider an optimal contract between an entrepreneur and an investor where the entrepreneur is subject to a double moral hazard problem (one being the choice of production effort and the other being intertemporal substitution, which consists of transferring cash flows between periods). Investment and production effort may be below socially optimal levels because the entrepreneur cannot entirely capture the results of his effort. The opportunity to manipulate earnings protects the entrepreneur against the risk of a low payoff when the results of production are low. Ex-ante, this provides an incentive for the entrepreneur to increase his level of effort and invest efficiently