The accounting art of war: Bounded rationality, earnings management and insider trading

The study uses the idea of a multi-faceted managerial strategy and examines the effects of bounded rationality and ethical compass on insider trading, earnings management, and managerial effort. The analysis establishes that bounded rationality and the ethical compass play an important role in the managers’ decisions. As such, the study provides an insight into why managers would engage in schemes that could potentially ruin their lives. The analysis also demonstrates that earnings management has multi-period dynamic properties, while the effort and insider trading decisions are made independently each period. Another interesting finding is that that earnings manipulation can only occur in a world with ethically diverse managers. Contrary to common wisdom, the study shows that shareholders have a vested interest in eliciting income management because it boosts their wealth. Consequently, expected market losses to shareholders’ value, in response to detected accounting manipulations, are necessary to mitigate shareholders’ preferences for earnings management. It is interesting to note that shareholders’ preferences for earnings management (balanced by the expected market losses) imply that they would not necessarily prefer to hire the most ethical and least ‘bounded rationality’ decision-making managers. Finally, the study examines the public policy implications of the topic in light of the recent US Senate Financial Regulation Overhaul bill.     

Contracting, signaling, and moral hazard: a model of entrepreneurs, ‘angels,’ and venture capitalists

Investment by wealthy individuals, known as ‘angels,’ in startup firms is quite significant and has taken off in the last few years. Angels invest in the company at an earlier stage than venture capitalists (VCs) do. This paper examines the relationship between an entrepreneur, an angel, and a VC from the seed investment made by the angel to the exit stage. The study characterizes the equilibrium contracts among the players and provides insights into the related institutional arrangements. Next, the study examines the signaling aspects of the game. The paper also analyzes the moral hazard problems of the entrepreneur and the VC. It shows that the outcome in a startup firm is not efficient because of the free-rider phenomenon.     

Transfer pricing rules and corporate tax competition

A multinational parent sells a non-marketed commodity to a foreign subsidiary that uses the product as an input to produce a product it then sells. The subsidiary is controlled by a local managing partner whose compensation consists of a lump-sum payment plus a share of the subsidiary's profit. The parent chooses an optimal transfer price taking into account incentives for the subsidiary's managing partner and taxes. Home and host governments impose corporate income taxes on the parent and subsidiary's respective profits subject to a transfer pricing rule (e.g. cost plus price method or comparable profit method). A Nash equilibrium is derived for effective tax rates chosen by home and host governments. We then examine harmonization and suggest that tax rates would be reduced.     

A classroom exercise on executive incentive compensation schemes

This paper describes a classroom exercise that has been used in several graduate courses. The exercise provides the students with a framework for understanding the rationale behind some of the mechanisms we observe in reality: incentive compensation plans for executives, Generally Accepted Accounting Principles (GAAP), auditing, and lawsuits against auditors. As such, the exercise provides some answers for several questions of ‘why’ before getting into the ‘how’ of reporting. The case can be used in courses dealing with financial accounting, managerial control and microeconomics in the MBA level.