As a result of the agency problem, earnings management may take place due to the high contracting costs, shareholders’ bounded rationalities, and information asymmetry. Therefore, three main groups of motives have been identified to explain earnings management behaviour at the contracting, capital market, and external levels. While the previous studies have individually examined those motives, this thesis provides evidence that they interact in determining earnings management behaviour.
The first empirical chapter of this thesis focuses on the contracting factors and examines the impact of earnings management on executive compensation conditioned on managerial ability. It finds that managers who utilize accrual earnings management receive higher compensation than those who undertake real earnings management. However, high quality managers are rewarded less for accrual earnings management and punished less for real earnings management.
The second empirical chapter examines the non-linear effect of market concentration as an external motive of earnings management. It documents that accrual earnings management increases in concentrated markets as the quantity of information decreases. However, the sophisticated real earnings management starts to substitute for discretionary accruals at higher levels of market concentration when the quality of information declines.
The third empirical chapter combines factors from the contracting and external motives. It examines the effect of market competition on the relationship between managerial ability and earnings management. The results show that in the face of increased competition, high quality managers manipulate earnings via accruals rather than more costly real earnings management.
Overall, the results of this thesis show that management compensation is a crucial factor in assessing the costs of earnings management at the firm level. An optimal level of market concentration exists and should be considered by the regulators. Finally, understanding how industry level factors influence managerial decisions at the firm level is essential to explaining earnings management behaviour.