“Earnings Management, Investment, and Managerial Turnover in a Dynamic Agency Model” by Mr. Tae Wook (Ryan) KIM
Mr. Tae Wook (Ryan) KIM
Ph.D. Candidate in Accounting
Tepper School of Business
Carnegie Mellon University
I develop a model to investigate how the internal control system influences a firm’s investment decisions. Contrary to the view that a strong internal control system mitigates CEOs’ incentives to manage earnings and increases investment efficiency, I find that a moderate internal control system, that allows appropriate reporting discretion to CEOs, can improve a firm’s investment decisions when past performance is poor. The essential mechanism is that, in the optimal contract, costly earnings management can act as an alternative punishment for poor performance and, thus, substitute for the threat of turnover. Because the possibility of turnover leads to an underinvestment problem (e.g. because a new CEO needs to learn about the ongoing projects and there are costs associated with searching for a new CEO.), a moderate internal control system can effectively improve investment efficiency. Also, an infinite-horizon dynamic model shows a positive relationship between investment and the level of earnings management for a given internal control system and an inverted U-shape relationship between investment and the internal control system. Finally, calibration results suggest that shareholders’ value under the current level of the internal control systems in the market is 0:4% higher than that under the counterfactual strongest internal control system.