Incentive to manipulate earnings and its connection to analysts’ forecasts, trading, and corporate governance

We develop a model where insiders’ decision to manipulate earnings is linked both to their stake and to corporate governance. We show how earnings manipulation affects analysts’ forecasts and institutional trading. More precisely, whenever there is “excessive” earnings manipulation, we observe less optimistic analysts. Furthermore, institutions exhibit positive feedback trading behavior and appear to “front-run” analysts’ errors. Finally, companies with strong corporate governance are less prone to these phenomena, being able to avoid the detrimental effects of insiders’ incentives. We then provide strong empirical evidence to support our model. Copyright Springer Science+Business Media, LLC 2012