Career Concerns and Earnings Management ∗Elizabeth Demers†

Chong Wang‡

August 2013

Abstract
Motivated by the disconnect between survey evidence documenting that executives prioritize implicit contracting (i.e., labor market based career concerns) when making earnings
management decisions (Graham et al (2005)) and the extant literature’s focus on explicit
contracting to explain earnings manipulation, we examine analytically the role of managerial career concerns in earnings management. Building on Holmstrom (1982, 1999), we
present a career concerns based earnings management model that incorporates the uniquereversing nature of earnings management. A key insight derived from the model is thatwhether the predictions of a traditional career concerns model prevail, which is to saythat managers engage in more income-increasing behavior in their early years, criticallydepends upon the reversal characteristics of the earnings management vehicle chosen.

JEL Classiﬁcation: M40, M41.
Keywords: earnings management; career concerns; accruals and real activities management;
reversal of earnings management.

∗
We thank Ana Albuquerque, Bill Baber, K.J. Euske, Jennifer Francis, Denis Gromb, Felix Höppe, Joe
San Miguel, DJ Nanda, Marco Trombetta, Moqi Xu, Neng Wang, as well as seminar participants at Bocconi,
Rotterdam School of Management at Erasmus University, the 6th Accounting Research Workshop in Bern, theStockholm School of Economics’ Summer Accounting Research Conference, and the AAA meeting in NYC for
helpful comments on earlier versions of this research note.
†
Darden School of Business, University of Virginia, 100 Darden Boulevard, Charlottesville, VA 22903. Email:DemersE@darden.virginia.edu.
‡
Corresponding author. Graduate School of Business and Public Policy, Naval Postgraduate School, Monterey, CA 93943. Email: cwang@nps.edu.

1Introduction
Top executives of US publicly-traded ﬁrms often face intense incentives to manage earn-

ings.1 Broadly speaking, executives can manage reported earnings in one of two ways. First,
managers may use “accruals management”, which refers to the discretion available within
Generally Accepted Accounting Principles (GAAP) to “ ‘obscure’ or ‘mask’ true economic
performance” (Dechow and Skinner (2000)). Alternatively, executives may use real activities
manipulation to alter the timing and amount of expenditures in order to aﬀect the current
period’s bottom line (e.g., cutting R&D expenditures).2 Most of the extant academic literature links the incentives for both real and accruals based earnings management, directly or
indirectly, to explicit contracts.3 While explicit contracting-based incentives undoubtedly play
an important role, the literature has been almost silent about the eﬀects of implicit contracts
and implicit incentives over earnings management4 even though a recent survey by Graham,
Harvey and Rajgopal (2005) documents that more than three quarters of responding executives consider upward mobility in the labor market (i.e., an implicit career incentive) to be
more important than short-run current compensation beneﬁts in inﬂuencing their earnings
management decisions.5 Our study addresses the apparent disconnect between this survey
evidence regarding the importance of implicit contracts and the extant literature’s focus on
explicit contracting explanations, by presenting a model of earnings management that builds
upon the seminal career concerns work of Holmstrom (1982, 1999). Speciﬁcally, we incorpo1

For an excellent and extensive academic summary of the earnings management literature, we refer thereader to Ronen and Yaari (2008). Prominent examples of non-academic sources of attention to the issue of
earnings management pressures include the famous speeches by Levitt (1998, 2003).
2
Unlike accruals earnings management, real activities earnings manipulations have direct cash flow consequences to the firm. Real activities management involves deviations from optimal business practices, such as
cutting discretionary expenses (e.g., R&D or advertising) or incurring abnormal production costs, with theprimary objective of upwardly manipulating the current period’s reported earnings.
3
Contracting-based motives for earnings management that have been examined include executive current
cash bonus maximization (Healy 1985), the avoidance of debt covenant violations (Defond and Jiambalvo
1994), more favorable equity and bond pricing (Teoh, Welch and Wong 1998a and 1998b; Aharony, Wang
and Yuan 2010; Higgins 2013), the reduction of debt renegotiation costs (Bohren and Haug 2006), politicalcost considerations (Key 1997; Patten and Trompeter 2003), and executive equity compensation (Cheng andWarfield 2005).
4
One exception is the study by Bowen, DuCharme and Shores (1995). These authors consider the impact
of various stakeholders’ implicit claims, notably excluding managerial career concerns, on accounting method
choices (i.e., not accruals or real activities management perse).
5
Furthermore, Gillan et al (2009) document that fewer than half of the CEOs of S&P 500 firms havecomprehensive explicit employment agreements.

1

rate features of the accrual accounting performance measurement system and the longer-termvalue-destroying eﬀects of real activities earnings management. While the traditional prediction of career concerns models is that managers will exert themselves more in their early years
in order to inﬂuence the labor market’s assessment of their quality, the major implication of
our model is that the extent to which managers engage income-increasing earnings management when they are young relative to old depends critically on the rate at which earnings
management reverses.
Our paper contributes to the literature by analytically demonstrating the role of careerconcerns in determining earnings management levels. Moreover, the model’s predictions do
not extrapolate from a traditional Holmstrom model, but rather they depend critically upon
the reversing nature of alternative earnings management channels.

2

Model

2.1

Model Setup and Assumptions

We develop a model of earnings management based upon managerial career concerns by building on the seminal work of Holmstrom (1982, 1999). As interpreted by Autrey, Dikolli andNewman (2007),“Career concerns are implicit incentives that arise because a manager expects future wages to be aﬀected by the labor market’s use of publicly-observable performancemeasures to assess the manager’s ability.” It is worth noting that a distinctive characteristicof career concerns models is that managers are incentivized by future, rather than current,
compensation.
To illustrate the eﬀects of career concerns, we adopt a simple three-period setting in which
the manager is young, established, and then retired in each respective period. In periods 1 and
2, the executive is responsible for managing the ﬁrm, while in period 3 the manager may serve
as a board member during retirement. Consistent with competitive labor markets being a key
premise underlying the general career concerns framework, we also assume that the manager ispaid, at the beginning of each period, the expected output that she will deliver in the current
period given her history of outputs.
2Let η denote the manager’s unobservable productivity. For simplicity, assume that ηremains constant over time, with the following prior distributionη ∼ N (m0 , 1/h0 )(1)where N ( · , · ) is the standard normal distribution function, m0 is the mean for the prior, andh0 is the precision of the prior (i.e., the inverse of its variance).
Let xt denote the reported output in period t such that x1 and x2 are the earnings reportedby the manager when she is young and established respectively, while x3 is the value addedfrom the manager’s post-retirement board service. During periods t = 1, 2 the manager may
manipulate accruals or engage in real activities to manage earnings. The period 1 reported
earnings are therefore given by
x 1 = η + α1 + ϵ 1 ,(2)

where α1 is the earnings management through accruals manipulation or real activities in period
1. ϵ1 is the shock, which is uncorrelated with the manager’s productivity η. Shocks in eachperiod are assumed to be normally distributed with precision hϵ , such thatϵt ∼ N (0, 1/hϵ ).

(3)

We assume that η, ϵ1 , ϵ2 and ϵ3 are jointly independent.
In period 1, when the manager is young, she can “impress” the labor market in the shortterm by boosting earnings via accruals manipulation or real activity choices. However, theamount of accruals manipulation in period 1 must be partially or fully reversed in period
2. This assumption states that earnings cannot be indeﬁnitely managed upward via accruals
without triggering a forced earnings restatement or fraud investigation, both of which areassumed to be associated with extreme penalties to the manager. In other words, the manager
needs to balance the books via accruals reversals “eventually,” although some portion of thereversal may occur in period 3, after the manager has retired. Accruals management decisions
are assumed to be value-neutral in that they only involve using the discretion allowed within
3

GAAP to aﬀect reported earnings, they do not impact real activities and thus real value
creation.
By contrast, real activity earnings management involves managers taking actions to adjust
the timing and/or scale of the ﬁrm’s underlying business activities away from their optimallevel. Alternatively stated, these activities are value-destroying. The real activities earnings
management in period 1 is therefore penalized (i.e., it reverses back) at a multiple rate inperiod 2. This assumption that accruals reversal is at most dollar-for-dollar while the reversalof real activities is more than dollar-for-dollar will be shown to have important implications
for the predictions of the model.
In period 2, when the manager is at the established stage of her career, the period 1 earnings
manipulations (accruals or real activities) begin to reverse and the manager has the option
to engage in a second round of earnings manipulations. Let α2 denote the amount of “new”
earnings manipulation in period 2. Reported output in period 2 is given byx2 = η + α2 − λα1 + ϵ2 ,(4)

where λ ≤ 1 if the channel of earnings management is accruals based, and λ > 1 if earnings
management is accomplished via real activities.
The second period’s earnings manipulations also reverse in the subsequent period, after
the manager is retired. Because the period 2 manipulations will reverse only when the ﬁrm
is under new management, however, the retired manager will bear no “direct” consequencesfrom her period 2 earnings manipulation since the market will not incorporate the third period
earnings reversal when inferring the manager’s productivity (i.e., her type). Therefore, theonly mitigating force for the manager not to engage in excess manipulation in period 2 isthe convex cost of manipulating earnings.6 Let c(α) denote the cost associated with earnings
manipulation, with the standard properties of c′ (α) > 0, c′′ (α) > 0, and c′ (0) = 0.
6

Consistent with the notion that there are costs associated with earnings management that are borne by
executives, Hazarika et al (2012) provide empirical evidence that CEOs who manage earnings have a greater
likelihood of experiencing a forced turnover. See also Liang (2004), who discusses the executive’s costs ofearnings management at greater length.

4Lastly, the retirement period 3 output, x3 , is given byx3 = η + ϵ3 ,(5)Let wt denote the executive’s wage in period t, paid at the beginning of period t. The assumptions of competitive labor markets and no explicit performance-based pay lead to thefollowing:

2.2

w1 = E(x1 |prior),(6)w2 (x1 ) = E(x2 |x1 ),(7)

w3 (x1 , x2 ) = E(x3 |x1 , x2 ).

(8)

The Derivation of Optimal Earnings Management Levels

The executive’s objective is to maximize her utility function, which is represented as thediscounted present value of her lifetime compensation, net of the cost of earnings management:][
U = E w1 − c(α1 ) + β(w2 − c(α2 )) + β 2 w3 ,(9)where 0 < β < 1 is the executive’s subjective discount factor.
Substituting (5) into (8) yields:
w3 (x1 , x2 ) = E(η|x1 , x2 )(10)Let α1 and α2 denote the labor market’s conjectures of α1 and α2 , respectively. z1 and z2
represent the market’s conjectures of unmanaged earnings, deﬁned as:z 1 ≡ x 1 − α 1 = η + ϵ1(11)z2 ≡ x2 − α2 + λα1 = η + ϵ2 .

(12)

We apply the standard belief updating formula to obtain the conditional distribution of η
5given z1 and z2 as follows:7(
η|(z1 , z2 ) ∼ N m0 +hϵ1(z1 + z2 − 2m0 ),h0 + 2hϵh0 + 2hϵ

)
.

(13)

Thus, the market begins with prior m0 , and adjusts its beliefs about η based upon theinformation conveyed by z1 and z2 . Similar to Holmstrom (1982, 1999) and other careerconcerns models, both the market and the manager are equally informed about managerial
ability in all periods, all participants learn about the manager’s type in the same way, andthere is no information asymmetry.8 The manager does try to inﬂuence the market’s inference
about her type, and consequently a moral hazard issue will arise, however in equilibrium noone is fooled. Thus, the market correctly anticipates the level of earnings management inequilibrium, and z1 and z2 are known in equilibrium given the observed outputs in periods 1
and 2, x1 and x2 , respectively.
The wages are given by:
w3 (x1 , x2 ) = E(η|x1 , x2 ) = m0 +hϵ(x1 + x2 − α2 + (λ − 1)α1 − 2m0 )h0 + 2hϵ(14)

h0 m0 + hϵ (x1 − α1 )+ α2∗ − λα1h0 + hϵ(15)

w2 (x1 ) = E(η|x1 ) + α2∗ − λα1 =w1 = E(x1 |prior) = E(η|prior) + α1 = m0 + α1∗(16)where we rely on the standard belief updating formula for the substitution of E(η|x1 ) =ϵm0 + h0h+h(z1 − m0 ) into equation (15). We also rely on the assumption that all players (i.e.,ϵthe manager and the market) are able to determine the optimal α2∗ by solving the backward
induction problem in a perfect Bayesian equilibrium. This implies the following ﬁrst orderconditions for period 2, where the manager chooses α2 to maximize E{−c(α2 ) + βw3 } using(14):−c′ (α2 ) + β
7
8

hϵ
= 0,
h0 + 2hϵ(17)See, e.g., Greene (1997) Theorem 3.6 on marginal and conditional normal distributions.
In other words, neither our model nor the standard careers concerns setup are adverse selection models.

6

which in turn implies the closed form solution:c′ (α2∗ ) = βhϵ.
h0 + 2hϵ(18)

The ﬁrst order derivative with respect to α1 is:hϵhϵ∂U= −c′ (α1 ) + β+ β2(1 − λ),∂α1h0 + hϵh0 + 2hϵ(19)which in turn implies the closed form solution:c′ (α1∗ ) = β

hϵ
hϵ
+ β2
(1 − λ)h0 + hϵh0 + 2hϵ(20)

The ﬁrst order conditions in (18) and (20) guarantee a maximum value for the objectivefunction given that the second-order conditions are satisﬁed.

2.3

Interpretation of Optimal Earnings Management Levels

We now discuss and interpret the optimal levels of earnings management in periods one andtwo, i.e., α1∗ and α2∗ for the cases of accruals and real activities earnings management each inturn.

Case 1 - Accruals: λ ≤ 1
The case of λ ≤ 1 implies a partial or full reversal of period 1 earnings management activities in period 2, and is thus applicable to accruals channeled earnings management. If
λ ≤ 1 , then from (18) and (20), we have: c′ (α1∗ ) > c′ (α2∗ ), which immediately translates to
α1∗ > α2∗ . This scenario therefore results in predictions that are similar to those of the classicalHolmstrom career concerns model, with managers exerting more eﬀort when they are young
in order to improve the labor market’s perceptions of their abilities.

7

Case 2 - Real Activities: λ > 1
The numerous cases discussed below, each with λ > 1 and thus implying more than full reversal of period 1 earnings management activity in period 2, are applicable to value-destroying
real activities earnings management.

ϵSub-case 2.1: 1 < λ < 1 + β1 h0h+hϵUnder this scenario, c′ (α1∗ ) > c′ (α2∗ ) and thus α1∗ > α2∗ still holds. As a consequence,
the model suggests that, provided the real activity earnings management is not very valuedestroying, younger managers’ desire to impress the labor market early on will dominate the(discounted) negative impact of the ampliﬁed reversal in the second period. that is, the reversing nature of the ﬁrst period activities is not suﬃcient to overturn the standard careerconcerns result of higher early period eﬀort.

ϵSub-case 2.2: 1 < λ = 1 + β1 h0h+hϵUnder this scenario, c′ (α1∗ ) = c′ (α2∗ ), implying α1∗ = α2∗ . Thus, when the value destroying eﬀectof a particular real earnings management reaches a speciﬁc level, a younger manager exerts
neither more nor less earnings management eﬀort in her earlier career relative to her later
years. This is the tipping point at which the beneﬁts of managing earnings more when the
manager is young are exactly oﬀset by the (discounted) negative impact of reversal when she
is old.

ϵϵSub-case 2.3: 1 + β1 h0h+h< λ < 1 + β1 hh00+2h+hϵϵUnder this scenario, 0 < c′ (α1∗ ) < c′ (α2∗ ), leading to 0 < α1∗ < α2∗ . In other words, whenreal activity earnings management is very value-destroying, the younger manager’s desire to
impress the labor market yields to her concerns regarding the anticipated negative reversal
eﬀect in the later years of her career. Thus, the results run contrary to the standard career8

concerns model; managers will engage in less real earnings management activity when they
are young.

ϵSub-case 2.4: 1 + β1 hh00+2h+hϵ ≤ λIn this case, c′ (α1∗ ) ≤ 0, leading to the corner solution of α1∗ = 0. Thus, in the situation wherereal activities management is extremely value-destroying, younger managers will refrain fromdoing any such activity because even low levels of this kind of earnings management will leadto a loss of utility.

2.4

Discussion

The key insight from our model is that the extent to which the predictions of the traditional
career concerns model prevail in an earnings management setting (i.e., whether the manager
exerts more eﬀort towards earnings management in their early versus their later years) is
critically dependent upon the rate at which the period 1 earnings management reverses (i.e.,λ). Figure 1 provides a graphical depiction of this relation between the equilibrium levels of
earnings management at diﬀerent career stages (i.e. α1∗ and α2∗ ) and the extent to which theearly career stage earnings management reverses prior to the manager’s retirement (i.e., λ) .
Insert Figure 1 hereϵAs shown, for any λ less than λ∗ = 1 + β1 h0h+h, the traditional career concerns eﬀectϵdominates and managers engage in more income-increasing earnings management when they
are young. The opposite prediction holds, however, once λ exceeds the tipping point, λ∗ .
Beyond this point, the manager’s concerns over the negative impact of reversal on her future
wage dominates her desire to signal her quality to the labor market in the early years suchthat the younger manager will engage in less of this type of earnings management. Once λϵreaches 1 + β1 hh00+2h+hϵ , such concerns become so prohibitive that the manager does not engage

in any such real activities earnings management early on.

9We make a few additional observations regarding the model. First, while the optimal
amount of earnings management in period 1, α1∗ , is monotonically decreasing with λ, theoptimal amount of earnings management in period 2, α2∗ , is a constant that is independent of
λ.9
ϵSecond, we note that the magnitude of the tipping point, λ∗ = 1 + β1 h0h+h, is negatively
ϵrelated to both β (the discount factor) and the ratio of the precision of prior information
to the precision of new information ( hh0ϵ ). Intuitively, a larger β implies that damage on
future wages that arises from reversal are discounted less (i.e., the costs of future reversals areweighted more heavily) and therefore it takes a lower value of λ to ﬂip the equilibrium from a
traditional career concerns result with higher earlier career eﬀorts to one where the concerns
over the negative impact of reversals dominates such that there is lower early stage earnings
management. Furthermore, greater values of h0 relative to hϵ , imply that priors are relatively
more informative than new information, and thus new information does not weigh heavily inthe market’s assessments of the manager’s quality. Accordingly, when the market has more(less) precise prior information and less (more) precise new information, there is less (more)
propensity for the manager to engage in earnings management activities in order to inﬂuence
the labor market’s perceptions and thus a smaller (bigger) value of λ∗ is needed to reach thetipping point.
Lastly, because the manager’s wages are assumed to be determined at the beginning ofeach period based upon expected output, the model eﬀectively assumes away the role of explicit compensation contracts. The latter entail compensation being paid at the end of theperiod based upon realized output. Accordingly, all of the model’s predictions derive solely
from managers’ career concerns, which are characterized by implicit incentives and implicit
contracts.
hϵϵThe monotonically decreasing relation between α1∗ and λ is established by c′ (α1∗ ) = β h0h+h+β 2 h0 +2h
(1−λ)
ϵ
ϵ
∗
′
∗
hϵ
while the independence of α2 is implied by c (α2 ) = β h0 +2hϵ .
9

10

3

Conclusion

We analytically investigate the impact of managers’ career concerns on their earnings management decisions. Largely building upon the classic work of Holmstrom (1982, 1999), we
incorporate the unique reversing feature of earnings management and generate important predictions. The key message conveyed is that not all earnings managements are created equal.
Settings where the magnitude of a particular earnings management reversal is smaller yieldoutcomes that are similar to traditional career concerns results (i.e., more eﬀort will be expended toward this activity in the early years). By contrast, settings in which a particularreal activity earnings management is very value destructive lead to the opposite outcome oflower levels of early career stage earnings management. Our ﬁndings are novel to the literatureand help to bridge the disconnect between survey evidence that documents that executivesprioritize implicit contracting (i.e., labor market based career concerns) when making earnings management decisions (Graham et al (2005)) and the extant literature’s focus on explicit
contracting as an explanation for earnings manipulation.

11

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13

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14

Figure 1: The earnings management levels at equilibrium ( α ) versus the magnitude of earnings
management reversal ( λ )α1* = α 2*

α1* = 0α1* > α 2*

α1* < α 2*

Traditional careerconcern effectdominates

The concern over thereversal damages
dominates

α

α1*
α 2*

λ*
1+

1

β

*

λ

hε
h0 + hε

15

1+

1

β

*

h0 + 2hεh0 + hε