The Effect of Financial Incentives and Career Concerns on Reporting Bias

We consider a manager’s decision to bias earnings reports if he faces both financial incentives and career concerns. Previous theoretical literature extensively studies the effect of financial incentives on earnings management, showing that managers tend to inflate earnings reports if they are compensated for stock price movements. Although career concerns have undoubtedly impact on managerial decision making, there is only scarce theoretical insight into their implications for reporting bias. Our analysis gives new insights on the simultaneous effects of financial and career incentives on reporting bias assuming that earnings provide information on firm value and managerial talent. If the manager’s reporting objectives are unknown, the financial market and labor market incentives are not independent, but have substitutive effects. We identify conditions under which – for given financial incentives – stronger career incentives reduce the average reporting bias. Reporting bias might even fall below the level which occurs when only financial incentives are provided.