J. Account. Public Policy: Ramy Elitzur

J. Account.
Public Policy xxx (2010) xxxxxx
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J. Account. Public Policy

journal homepage: www.elsevier.com/locate/jaccpubpol
The accounting art of war: Bounded rationality, earnings

management and insider trading
Ramy Elitzur
Rotman School of Management, University of Toronto, 105 St. George St., Toronto, Ontario, Canada M5S 3E6
a r t i c l e
i n f o
a b s t r a c t
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 nding 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.
2010 Elsevier Inc. All rights reserved.
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E-mail address: elitzur@rotman.utoronto.ca
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doi:10.1016/j.jaccpubpol.2010.11.002
Please cite this article in press as: Elitzur, R. The accounting art of war: Bounded rationality, earnings management and insider trading. J. Account. Public Policy (2010), doi:10.1016/j.jaccpubpol.2010.11.002
R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx
1. Introduction
Appearance and intention are fundamental to the Art of War. Appearance and intention mean the
strategic use of ploys, the use of falsehoods to gain what is real. (Yagyu Munenori, The Book of Family
Traditions on The Art of War)
The fact that decision makers are not rational has been acknowledged in Finance (e.g., Thaler, 1993,
2005), Game Theory (Camerer, 2003), Economics (e.g., Abreu and Brunnermeier, 2003), and Accounting (Hirshleifer et al., 2004). Surprisingly, despite the extensive research on earnings management, the
literature so far has focused on rational decision makers only.1 In contrast, this study examines the
earnings management behavior of a public rm in light of bounded rationality.
Earnings manipulation has interested accounting researchers for a while.2 Trading on private
information by insiders is an interesting dimension of this phenomenon that, despite various related
empirical ndings (for example, Beneish and Vargus, 2002; Park and Park, 2004; Bartov and
Mohanram, 2004; Cheng and Wareeld, 2005), has not been modeled yet.3 This paper, in contrast with
other models of earnings management, bridges the gap between the two phenomena by incorporating
endogenously strategic trading of securities by managers (based on inside information) and analyzing
it in tandem with earnings management and managers effort. Moreover, these actions are shown to
be profoundly inuenced by bounded rationality and inherent ethics.
One criticism with respect to earnings management models is that any meaningful analysis of the
managers decisions on earnings management, insider trading and their efforts cannot be captured in a
single period model. Almost all of modeling studies on the topic of earnings management use single
period models (two notable exceptions are the studies of Dye (1988) and Elitzur and Yaary (1995)).
To address this concern, a multi-period dynamic model is used to capture the long-term aspects of
the relationship between the manager and the rm.
Another criticism of earnings management models, particularly those based on the principalagent model, which is addressed in this study, is the absence of a capital market from the analysis.
As such, the paper provides a rich setting and analysis which helps explore the related public policy
implications of these managerial behaviors in light of the recent US Senate Financial Regulation
Overhaul bill.
The study shows that bounded rationality and the managers ethical compass play an important
role in managerial earnings manipulation strategy. The analysis also establishes that, along the optimal path of control variables, the choice of earnings management by management has multi-period
dynamic properties while the choices of effort and insider trading are made independently each period. The study demonstrates that, contrary to common wisdom, shareholders have a vested interest in
eliciting income manipulation because it enhances their value. Consequently, in order to mitigate
shareholders preference for earnings management, it is necessary for them to expect with some probability some market imposed penalties on detected accounting manipulations. The study also shows
that shareholders will want to hire the least effort-averse managers, and, in turn, ceteris paribus, this
will lead to higher managerial effort. A surprising result is that shareholders preference for managerial earnings manipulation (balanced by expected market losses) implies that they would not necessarily hire the most ethical managers, or the ones who exhibit a lesser degree of bounded rationality.
Finally, the study examines the public policy implications of the recent US Senate Financial Regulation
Overhaul bill on earnings management and insider trading.
The paper proceeds as follows: Section 2 describes the model; Section 3 examines the managers
decisions concerning earnings management, insider trading and managers effort and the effects of
1
This problem has been acknowledged by Wilson (1983), who starts his discussion of the accounting and auditing literature by
expressing discomfort at the idea of assuming rational agents in accounting and auditing.
2
Example of such studies include Dye (1988), Merchant (1990), Bruns and Merchant (1990), Elitzur and Yaary (1995), Evans and
Sridhar (1996), Demski (1998), Arya et al. (1998), Demski and Frimor (1999), Bagnoli and Watts (2000), Fischer and Verrecchia
(2000), Christensen et al. (2002), Demski et al. (2004), Park and Park (2004), Liang (2004), Ewert and Wagenhofer (2005), Graham
et al. (2005), Goldman and Slezak (2006), Guttman et al. (2006), Ronen et al. (2006), Ronen and Yaari (2007a,b), and others).
3
The exception is Ronen et al. (2006), which focuses on insider trading by directors, not managers, and uses a single period
model.
bounded rationality and ethics; Section 4 deals with owners decisions; Section 5 offers some public
policy implications. Concluding remarks are offered in Section 6.
2. The model
2.1. The time line
The rm is modeled via a principal-agent contract between owners and managers. The time line of
their relationship is depicted in Exhibit 1. The setting in this study is a multi-period dynamic setting
where the manager is hired by the owner to operate the rm (event 0 in Exhibit 1 below). The expected tenure of the manager with the rm is T periods. The managers compensation consists of a
cash bonus which is based on a fraction, k, of reported income, R(t), and equity holdings in the rm
whose value is linked to the capital market (see Appendix A for a complete description of the notations
we use in this study). In each period, the manager operates the rm (event 1 in Exhibit 1) and then
assesses future streams for the rm (event 2 in Exhibit 1). Based on his or her observations, the manager decides on the optimal paths over time of earnings management, h(t), insider trading, I(t) and
managerial effort, a(t) (event 3 in Exhibit 1). These three decision variables are the control variables
in the managers problem. The manager then implements the trading and effort strategies (event 4
in Exhibit 1). The managers effort affects the rms economic income, p(t), which can be observed
only by the manager (event 5 in Exhibit 1). Based on his pre-determined reporting strategy, the manager then (event 6 of the Exhibit) releases his report of income, R(t), which consists of economic income, p(t), plus an earnings management accrual, h(t), that can assume any sign. The report is then
analyzed by all players other than the manager (event 7), and is followed by the markets reaction
(event 8). The last event in the time line is the awarding of a cash bonus and equity holdings to the
manager (event 9). This sequence of events is repeated for every period until T (node 10 of the Exhibit).
2.2. The setting
2.2.1. The managers preferences and bounded rationality
It is assumed that the manager is risk-neutral and that (s)he discounts his or her expected periodic
b t, at a discount rate, denoted as r, resulting in a discount factor qt 1 t . The manager
payoff, C
1r
selects his level of effort, a(t), at a cost, la(t). Consequently, the manager in this model is risk-neutral
Exhibit 1. Time line.
but effort averse. We assume that he has limited wealth and cannot purchase the rm from shareholders. Similar to Elitzur and Yaary (1995), we assume that the manager does not go bankrupt, i.e.,
Pt
b
i1 qi C i P 0. In essence, this is equivalent to the reservation utility constraint in the principalagent literature. Short sales, however, are allowed in periods prior to T. The possibility of the manager
deliberately causing the dissolution of the rm is also ruled out. This last assumption can be justied
based on the detrimental effects of bankruptcy on the managers reputation and, consequently, on his
or her market value (i.e., the assumption is that the managers cost of dissolving the rm, deliberate or
not, exceeds his or her gain from it).
The term bounded rationality, that I use, relates to the concept of temporal myopia, or the managers focus on the here and now, instead of looking at the long term implications of their decisions.
The denition that the model utilizes is consistent with Ariely (2008), who describes decisions that
emphasize instant gratication at the expense of the long term. This denition is also consistent with
the literature of inter-temporal and hyperbolic discounting (e.g., Gigerenzer and Selten, 2002, p. 32
33; Soman et al., 2005; Dasgupta and Maskin, 2005). While the study uses one denition of bounded
rationality, there are, of course, other denitions (for example, focusing on the agents inability to process information optimally). Embedding bounded rationality endogenously in earnings management,
as this study does, is an important contribution that provides an intuitive explanation of why smart
managers engage in accounting manipulations, which are foolish in the long run, and can potentially
utterly ruin their lives.
2.2.2. The capital market
Ronen et al. (2003) show that earnings response coefcients will hold in a capital market with rational expectations. Consistent with this, the capital market reaction to reported earnings is based on
the following equation
DPt bpt ht b
F t
Pt1
Pt1
where DP(t) denotes the change in price in period t; p(t) and h(t), as dened above, are the components of reported income; b
F t is the earnings forecast for the period, i.e., the term in brackets is
the earnings surprise; b is the earnings response coefcient; and Pt1 denotes the previous price (note
that DP(t) divided by Pt1 is the rate of return in period t). Multiplying both sides by Pt1 provides for
the following equation of motion governing the periodic rate of change in P:
DPt bpt ht b
F t
Similar to Ronen et al. (2003) and Ewert and Wagenhofer (2005), this equation of motion, in essence,
constitutes the markets response function, and this, in turn, allows us to nd the equilibrium of the
game.
2.2.3. Trading on inside information
The managers decision to trade securities, based on superior information, takes place in addition to
his or her decisions on the choice of earnings management and level of effort. One can distinguish between the terms insider trading, which refers to trading on inside information, and trading by insiders,
which is not necessarily based on inside information. For our purposes the term Insider Trading denotes the former. The net number of securities sold (bought) in time t is I(t) leading to the net trading
cash in-ow (out-ow), or G(t) = I(t)DP(t). The payoffs for such activities can be quite substantial:
Although the reasons why corporate insiders choose to trade or not to trade in their rms securities
remain unclear, the conclusion that insiders on average earn superior returns on their trading activity
is well documented (Fowler and Rorke, 1988; Seyhun, 1986; Givoly and Palmon, 1985; Finnerty,
1976; Jaffe, 1974). This result suggests that trading by insiders, on average, is based on superior information about their rms. (Allen and Ramanan, 1990, p. 519)
The ndings above indicate that managers often choose to engage in insider trading activities (as is
also shown by recent US cases). This activity, however, carries the risk of being found out and suffering
a signicant (though not unbounded) penalty, on top of the potential legal issues.
^ Gt be the expected penalty on the managers trading on inside information imposed by the
Let x
^ Gt, is a function of the trading on inregulatory agency, say, the SEC. The expected penalty paid, x
side information, i.e., it is an increasing function of the absolute value of both insider trading, I(t) , and
reported income, p(t) + h(t). In order to insure an interior solution, we assume that the second
derivative of this penalty with respect to either I(t), p(t) or h(t) is positive, respectively,
^ II t > 0; x
^ pp > 0 and x
^ hh t > 0. Note that since the penalty is dened on the absolute value of
x
the units traded, I(t) can have any sign.
2.2.4. Earnings management
In the end, many of our results are disturbing. The majority of CFOs admit to sacricing long-term economic value to hit a target or to smooth short-term earnings. (Graham et al., 2005, p. 36)
The manager chooses the earnings management accrual h(t) that maximizes his or her payoff. As I
argue next, this is not a costless choice. Karpoff et al. (2008a) show that 93.4% of the managers of rms
that were identied by regulators as having earnings management were red and suffered other
nancial consequences. As such, it is assumed that earnings management carries an expected cost
to the managers, ^
dht. This raises the question of how this cost would differ among managers, given
the same earnings management amount, and the same probability of detection. I argue that the expected penalty on earnings management is manager-specic because he or she would have a subjective assessment of the individual expected cost, i.e., his or her individual ethical capacity. It thus
follows that an ethical manager i can be characterized as one whose ^
dht is higher for every h(t) than
an unethical manager. This can be expressed as follows:
dbi ht > dbj ht8ht
Karpoff et al. (2008b) show that when earnings management is detected by regulators the ensuing
^ ht represents the expected loss to
losses imposed by the market are substantial. Consequently, u
shareholders from earnings management, even if h(t) is unknown to shareholders.
2.2.5. The conuence of earnings management and insider trading
The literature shows that managers opportunistically manage earnings to maximize their payoffs,
thus it is reasonable to expect that they would also opportunistically trade securities, based on their
inside information. As several empirical studies have shown (e.g., Beneish and Vargus (2002), Park and
Park (2004), Bartov and Mohanram (2004), and Cheng and Wareeld (2005)), managers do indeed
manipulate earnings and engage in insider trading simultaneously. Consequently, as this study illustrates, we need to study both parameters simultaneously. To date, there is been a dearth of studies
which examined both earnings management and insider trading4 and thus this paper, in contrast to
other models of earnings management, bridges the gap between the two phenomena by incorporating
endogenously strategic trading of securities by managers (based on inside information) and analyzing
it in tandem with earnings management and managers effort.
2.2.6. The ownermanager relationship and the managers program
The manager is hired by the owner to operate the rm. At the time of contracting, the owner knows
that the managers total payoff is dened by the sum of his or her discounted expected periodic payoff,
but the former does not know the values of these variables. The contract between the parties in its
most general form is made of: (1) a cash bonus as a fraction, k(t), of reported income, p(t) + h(t);
and (2) equity holdings in the rm. Such compensation schemes are quite common in practice. The
economic income of the rm, p(t),is a function of the managers effort, a(t).
Consistent with the above discussion, the managers problem is to maximize his or her objective
functional (4) subject to constraint (5)(7):
4
Please see Footnote 3 above.
Max
at;lt;ht
T
X
b
qt Ct
t1
The components of (4) are dened as follows:
b
^ Gt lat ^dht
Ct
ktpt ht DPtIt x
DPt bpt ht b
F t
s.t.:
and
T
X
ht 0
t1
The objective functional (4) describes a decision by the manager with an uncertain payoff. The total
expected payoff of the manager over time comes from his or her expected discounted periodic payoffs.
b t, as described in Eq. (5), is equal to an annual bonus, as a
The managers expected periodic payoff, C
percentage, k(t), of expected reported income, [p(t) h(t)], plus net gain from sales of securities,
^ Gt, the cost of managerial effort,
G(t) = DP(t)I(t), less the expected penalty to insider trading, x
la(t) and the expected cost to the manager of earnings management, ^dht. Constraint (6) describes
the equation of motion that governs the periodic rate of change in price according to the above formulation of the capital market. This equation of motion, in essence, provides the response function of the
market to earnings management, and thus, the manager, a Stackelberg leader, formulates his strategy
P
given the response function of the market, a Stackelberg reactor. Constraint (7), Tt1 ht 0, states
that, over time, the sum of total accruals from earnings management, h(t), is zero. Consequently, constraint (7), is, in essence, equivalent to the clean surplus concept.5 The managers problem is analyzed
in Appendix B.
3. The relationship between bounded rationality, ethics, insider trading, earnings management,
and managerial effort
What started as a marginal gap between actual operating prot and the one reected in the books of
accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew, he wrote. It was like riding a tiger, not knowing how to get off without being
eaten. (Ramalinga Raju, the chairman and co-founder of Satyam, on the Satyam Scandal inTimmons,
2009)
Appendix B provides the analysis and solution to the managers program described in objective
functional (4) subject to constraints (5)(7). One of the interesting features of the solution is that
the only choice variable for the manager, that exhibits dynamic properties, is earnings management,
h(t). As A(6) in the appendix shows, the managers optimal insider trading at each period, I(t), is at the
^ G t, is equal to 1.
point where its marginal expected penalty on the gain from insider trading, x
^ G t 1
x
Next, we show that the optimal effort by the manager at each period, a(t), is at the point where its
incremental increase in the annual bonus, pa(t)k(t), is equal to its marginal cost of effort, l.
pa tkt l
[See (A7) in the appendix for derivation of (9)].

5
The clean surplus constraint here is an important one as it prevents the model from collapsing.
Next, the derivation of the optimal earnings management operator is shown:
qtkt ^dh t qTkT ^dh T 0
10
[See (A8) in the appendix for derivation of (10)]. The above rst-order condition states that the choice
of the earnings management accruals, h(t), is made taking into account both its present period impact,
qtkt ^dh t, and its impact on the last period of the game, qTkT ^dh T, due to the clean surplus concept. Eq. (10) provides us with the insight that if owner sets in advance a positive k(T), then,
ceteris paribus, in the absence of bounded rationality, it will reduce earnings management. Whether
this is what the owner wants to do or not remains to be seen until we solve the owners program. Eq.
(13) also leads to the following insight:
Proposition 1. Managers who are bounded rationality decision makers will employ a more aggressive
earnings management strategy than others. On the other hand, bounded rationality does not affect the
choice by managers of their effort over time, a(t), or insider trading, I(t).
All proofs are relegated to Appendix B, Panel C.
Proposition 1 is interesting as it is consistent with Timmons (2009). It also provides a novel result:
the relationship of earnings management to bounded rationality. The Proposition stems from the fact
that, as Eq. (10) above illustrates, the optimal trajectory of earnings management considers inter-temporal dynamics and, thus, managers who are bounded rationality decision makers, i.e., temporally
challenged, and weigh mostly the here and now, as opposed to the long term effects of their choices.
Consequently, such managers will engage in more aggressive earnings management than others. At
the same time the choices of effort and insider trading are made independently each period and thus
bounded rationality will have no impact. Proposition 1 also illustrates why a multi-period model is
essential for the studying of earnings management as it is affected profoundly by inter-temporal
dynamics. This result is consistent with Graham et al. (2005) who nd that managers are willing to
sacrice long term value in order to gain short term benets, and that they employ simple decision
rules or heuristics instead of sophisticated and complex decision framework.
Next, we show that for earnings management to exist, the expected penalty on earnings management must be manager-specic and unobservable.
Proposition 2. If all managers would have the same known expected penalty function, ^
dt, and the same
time preferences, q(t), then h(t) would be observable as well.
Proposition 2s contribution lies in the fact that it characterizes the conditions under which earnings management occurs. As argued in the discussion of earnings management in Section 2.2.4 above,
the expected penalty on earnings management is manager-specic because he or she will have a subjective assessment of the individual expected cost, i.e., because of each individuals inherent ethical
compass.
This denition leads to the next insight, which is straightforward:
Proposition 3. Ethical managers will be less likely to engage in earnings management.
Proposition 3, together with Proposition 2, implies that earnings management could exist only in a
world with ethically diverse managers because otherwise such manipulations can be inferred. Next,
we analyze the effects of executive compensation on management behavior.
Proposition 4. The effects of the periodic bonus fraction awarded to the manager, k(t), on managerial
effort, insider trading and earnings management are as follows:

dat
>0
dktatat

dIt
0
dktItIt

dht
>0
dkththt
Proposition 4 implies that an increase in the bonus fraction awarded to the manager, k(t), will increase
the managerial effort, a(t), and in turn on the periodic economic income, p(t). At the same time an increase in the bonus fraction awarded to the manager, k(t), will also increase earnings management,
h(t), but will have no effect on insider trading, I(t).
Proposition 5. Along the optimal trajectories of control variables there is a negative correlation between
the managers cost of effort, l, and effort, a(t).
Proposition 5 is straightforward in its intuition. It also implies that the owner will try to hire a manager who is as little effort averse as possible, i.e., with the lowest l. Furthermore, if the cost of effort of
the manager is observable then the following holds:
Proposition 6. If managers costs of effort, ls, are observable, then their effort, a(t), and, in turn, economic
income, p(t), can be inferred.
Such a world, where one can observe how effort-averse managers are, is obviously unrealistic, and
hence we will relax this assumption in the next section and solve the owners problem.
4. The owners decisions
The owner in our model is a Stackelberg leader who sets the optimal executive compensation in
light of the opportunistic behavior of the manager. As such, the owner maximizes his or her overall
payoff, V, subject to the choice of effort, insider trading and earnings management by the manager.
As the owners objective functional (11) states, the owners periodic payoff comes from the change
in the value of the stocks that she or he owns, /DP(t), where a is the number of shares owned, less
executive compensation paid, k(t)[p(t) h(t)]and less market imposed losses to shareholders on earn^ ht. The substantial losses to shareholders that are documented by Karpoff et al.
ings management, u
(2008b) may seem unfair, as owners do not engage in earnings management but, as will be shown later, these losses serve an important enforcement role.
The managers choice of effort, insider trading and earnings management are depicted in constraints (12)(14), respectively. In order to simplify the math, I assume for the participation constraint
that the overall ex-ante expected payoff of the manager, U, is positive, otherwise, he or she will not
enter the relationship in the rst place and since the game takes place already when the manager
is engaged, this condition must be satised.
The owners problem is thus as follows:
Max
kt
T
X
^ ht
qt/ DPt ktpt ht u
11
t1
s.t.
at 2 arg max U
12
It 2 arg max U
13
ht 2 arg max U
14
at
It
ht
The detailed analysis of the owners program, which is provided in Appendix B, Panel B, leads to the
following Proposition:
Proposition 7. The optimal executive compensation, k(t) is as follows:
kt / b
pt ht
ch ht
1 u
1
^d
htht
h
i
t2
paapatkt
Proposition 7 stems from the fact that an increase in k(t) will increase both optimal effort, a(t), and
earnings management, h(t). This in turn will increase the wealth of the owner through his or her equity
holdings, via /b, but, at the same time, will also have an adverse effect because of executive pay,
hpthti h
i
pa t2
bh ht ^d 1 paa
1 u
tkt
htht
The next Proposition illustrates that the owner may prefer the manager to engage in earnings
management:
Proposition 8. Without the expected market imposed losses to the owners on earnings management,
^ ht, the owners would elicit earnings management from managers through the choice of executive
u
compensation, k(t).
Proposition 8 is consistent with Demski et al. (2004) who demonstrate that the principal could
directly help the agent in the self-serving manipulation of the accounting system. Proposition 8 arguably
extends Demski et al. (2004) who . . . employ a simple, stylized model (p. 43) but argue that their
insight can be extended to more general settings, as this study does. Next, we show the following result:
Proposition 9. Owners will attempt hiring managers with the lowest possible cost of effort, l, but not
necessarily the most ethical managers, or the ones that suffer as little as possible from bounded rationality.
The intuition behind Proposition 9 is that owner payoff is affected through economic income, p(t),
which increases in mangers effort, a(t), which, in turn, decreases in the cost of effort, l. As such, owners will attempt to hire the least effort-averse managers as much as they can. Similarly, since l is not
observable, owners will need to revert to costly to fake signals a-la Spence (1973) on the managers
effort averseness. Such signals about the manager may include, as in Spence (1973), education as a
costly to fake signal about the manager ability and his willingness to work hard. In addition, prior record can also provide a costly to fake signal about the managers low cost of effort. Owners, on the
other hand, as Proposition 9 illustrates, do not necessarily want managers to avoid manipulation of
earnings and thus they will not search for the ones who will be most ethical and will not exhibit
bounded rationality behaviors.
5. Some public policy implications
The US Senate has passed on May 21, 2010 the Financial Regulation Overhaul bill and, as the New
York Times (May 21, 2010) reports, the new bill . . . requires companies to have executive compensation set by independent directors and gives shareholders a nonbinding vote on those decisions. The
bill also stipulates the recovery of executive compensation . . . in the event that the issuer is required
to prepare an accounting restatement, due to the material noncompliance of the issuer with any nancial reporting requirement under the laws .... (Section 954).
The Senate bills requirement of enhanced disclosure of executive compensation and the relationship between pay and performance, in essence, forces the company to reveal k(t), which has profound
implications in this study (see Proposition 4 above) for managements earnings manipulation as well
as their effort. As such, it will also force shareholders to better disclose their implicit preferences for
earnings management, which were shown in Propositions 7 and 8 above.
Furthermore, it seems that the bill also intends, through the clawback of executive compensation
due to inaccurate nancial statements, to drive the cost of earnings manipulation to the managers,
^
dt, further up and, in turn, to reduce the magnitude of earnings management.
6. Concluding remarks
Often when teaching about accounting scandals, a question arises on how rational managers engage in such seemingly obtuse accounting manipulation schemes. The answer is, of course, that managers often are not rational players but fall into the bounded rationality trap. This is consistent with
some cases of observed earnings management (e.g., the aforementioned case of Satyam, where the
chairman and co-founder has confessed to engaging in a temporally myopic earnings management
10
behavior). As Timmons (2009) reported, the manipulation started small, in order to meet some compensation goals, and got out of hand over time.
If indeed bounded rationality plays a large role in managerial earnings manipulation it follows
that, as this study does, we need to model it explicitly and show its effects. The study shows that
bounded rationality leads to more aggressive earnings manipulation, as does the lack of an ethical
compass.
Surprisingly, shareholders, because of their own myopic agenda, will not always choose the most
ethical, or the least temporally myopic managers. The only factor that would curb this tendency is the
possibility of market backlash that could reduce shareholders wealth.
From a public policy standpoint, some analysis of the Financial Regulation Overhaul bill that was
passed on May 21, 2010 shows that the bill has some interesting provisions that are consistent with
the implications of this study.
The study could be extended by running experiments on the effects of bounded rationality and
inherent ethics on earnings management. The new FMRI (functional MRI) technology, for example,
could help us gure out if indeed the moral compass of managers affects their accounting choices.
Acknowledgements
The author thanks the editor of this journal and two anonymous reviewers, as well as David Brock,
Jeffrey Callen, Stacey Copans, Ted Kernaghan, Eileen Kim, Oded Lowengart, Ilanit Madar-Gavious,
Ayala M. Pines, and participants in the Ben Gurion Univesity Management Seminar and the Accounting
Seminar at the Rotman School of Management. The author also gratefully acknowledges the nancial
support from the Edward J. Kernaghan Professorship in Financial Analysis.
Appendix A. Some useful notations
a
b
C(t)
^
DP(t)
d
^
u
b
F
G
k
k
I
l
x
P
p
R
r
q(t)
h
U
V
managerial effort
total number of equity securities held by the owner
earnings response coefcient
managers payoff in period t
expectation operator
change in P
cost to managers of earnings management
market imposed losses to owners on earnings management
forecast of income
gain from insider trading
fraction of reported income awarded as cash bonus
audit intensity by the regulator
net number of securities sold (purchased) by the manager
marginal cost of managerial effort
penalty on insider trading
market price of an equity security
economic income of the rm
reported income
discount rate
discount factor at period t
earnings management accrual
overall payoff to the manager
overall payoff to the owner
11
Appendix B. Mathematical addendum

B.1. Some properties of the managers problem
Max
at;It;ht
T
X
qt Cb t
A1
t1
The components of (A1) are dened as follows:
b ktpt ht DPtIt x

^ Gt lat ^dht
Ct
A2
DPt bpt ht b
F t
A3
s.t.:
and
T
X
ht 0
A4
t1
b t is as
where the gain from insider trading is dened as G(t) = I(t)DP(t). Note that in lieu of (A4), C
follows:
"
b
CT
kT
pT
T1
X
#
^ GT latT ^d
ht DPTIT x
t1
T1
X
!
ht
A5
t1
Leading to the following rst-order conditions:
h
i
@U
^ G t 0 ! x
^ G t 1
qt bpt ht b
F t1 x
@It
A6
Using (A6) in the rst-order condition of (A2) with respect to the effort, a(t), yields the following:
@U
^ G t l 0 ! pa tkt l
qtpa tkt bIt1 x
@at
A7
Similarly, using (A6) in the rst-order condition of (A2) with respect to the earnings management,
h(t), yields,
@U
qtkt ^dh t qTkT ^dh T 0
@ht
A8
The above rst-order-conditions imply that only earnings management, as shown in (A8), displays
inter-temporal dynamics, while optimal effort and optimal insider trading are determined independently each period.
(A6), (A7) lead to the following relations:

U atkt
dpt
dat
pa tqt
pa t2
pa t
pa t
pa t

dkt atat
dkt atat
U atat
qtpaa tkt
paa tkt
>0
A9

U Itkt
dIt

0
dktItIt
U ItIt
A10

U htkt
dht
qt
1

>0
dkththt
U htht
qt^dhtht ^dhtht
A11

U atlt
dat
qt
1

<0
dltatat
qtpaa tkt paa tkt
U atat
A12
12
B.2. Some properties of the owners problem

The owners problem is as follows:
Max
kt
T
X
^ ht
qt/ DPt ktpt ht u
A13
t1
s.t.
at 2 arg max U
A14
It 2 arg max U
A15
ht 2 arg max U
A16
at
It
ht
The owners rst-order-condition with respect to k(t)is thus:
""
#
"
##
#

dpt
dht
c
1 uh ht
pt ht
qt / b kt
dkt atat
dkthtat
"
V kt
0
A17
Using (A9) and (A11) and rearranging,
kt / b pt ht=dpt=dkt jat
at 1 uh htdht=dktht at
/ b pt ht=1 uh t1=htht
A18
Using (A18), the effects of a(t) and h(t) on the payoff of the owner as follows:
2
6
V ht qt/ b kt qt6
4
pt ht
ch ht
1 u
1
^
dhtht
pa t2
paa tkt
7
ch ht7
iu
5
6 pt ht 7
V at V pt pa t qt/ b ktpa t qt4
5pa t > 0
p t2
1
^
dhtht
A19
A20
paaatkt
(A19) shows that in the absence of the substantial market imposed losses to shareholders on earn^ ht, shareholders will have positive incentives to elicit earnings management
ings management, u
behavior from managers through executive compensation, k(t).
B.2.1. Proofs of Propositions
Proof of Proposition 1. The idea here is that bounded rationality is dened by the length of the
horizon, T, even if all managers have the same discount rate (and thus the same q(t) for each t). The
proof on the effect of bounded rationality on earnings management is done through induction. Using
(A8) above implies managers with T = N will have a larger qTkT ^
dh T than managers with
T = N 1, while they both have the same qtkt ^
dh t. Next, we repeat the process of comparing
T = N 1 and T = N 2 and so forth. Consequently, for bounded rationality, or temporally myopic
manager, h(t) will be higher than other managers. Another angle to prove this Proposition is to use the
idea of Hyperbolic Discounting. (A8) above implies that for managers who suffer from bounded
13
rationality, or temporal myopia, the following will hold: lim qTkT ^

dh T 0, thus leading to a
qt0
modied (13), qtkt ^
dh t. Consequently, for such managers h(t) will be higher than other
managers.
In contrast, as (A6) and (A7) above demonstrate, inter-temporal dynamics have no effect on the
choice of a(t) and I(t) h
Proof of Proposition 2. Proof: Follows directly from (A8) above where earnings management can be
inferred. h
Proof of Proposition 3

U htdt
dht
qT qt

< 0
ddthht
U htht
qt^dhtht
Since the more ethical managers have a lower d(t) than the less ethical ones, i.e., dbi ht > dbj ht8ht
it will result in a less aggressive earnings manipulation by them than the less ethical managers. h
Proof of Proposition 4. Follows directly from A9, A10, and A11 in the appendix. h
Proof of Proposition 5. Follows directly from (A12), Appendix B, Panel B. h
Proof of Proposition 6. Eq. (A7) in Appendix B, Panel A, provides the solution for a(t), and thus it can
be reverse-engineered if l is observable, since all other factors are known. h
Proof of Proposition 7. Follows directly from (A18) in Appendix B, Panel B. h
Proof of Proposition 8. The effects of earnings management on the owners payoff are derived in
hpthti h
i and u
ch ht. Without the market
(A19), which has in it two components,
pa t2
bh ht ^d 1 paa
1 u
tkt
htht
ch ht, the effects of earnings management on the owners payoff

imposed penalty, and the resulting u
would be positive and thus, the owner would be interested in eliciting higher h(t) through the choice
of k(t). h

< 0, and since V increases in p(t), which
Proof of Proposition 9. From (A12) it follows that dat
dl
atat
increases in a(t) the following obtains:
dV
dl
atat

dpdVt pa tdat

dl
<0
atat
From Proposition (8) it follows that owners would want to optimize, as opposed to minimize, the effects of earnings management (as shown also in (A19) above) and thus they would not necessarily
want to hire the most ethical managers, or the ones that exhibit a lower degree of bounded
rationality. h
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Contents lists available at ScienceDirect

J. Account. Public Policy

The accounting art of war: Bounded rationality, earnings

Tel.: +1 416 978 3827; fax: +1 416 971 3048.

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

Exhibit 1. Time line.

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

dbi ht > dbj ht8ht

Please see Footnote 3 above.

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

The components of (4) are dened as follows:

[See (A7) in the appendix for derivation of (9)].

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

Next, the derivation of the optimal earnings management operator is shown:

qtkt ^dh t qTkT ^dh T 0

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

Appendix B. Mathematical addendum

The components of (A1) are dened as follows:

b ktpt ht DPtIt x

Leading to the following rst-order conditions:

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

B.2. Some properties of the owners problem

The owners rst-order-condition with respect to k(t)is thus:

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

rationality, or temporal myopia, the following will hold: lim qTkT ^

ch ht, the effects of earnings management on the owners payoff

R. Elitzur / J. Account. Public Policy xxx (2010) xxxxxx

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