Potential Prison Time and Earnings Management

Abstract

We examine the association between earnings management and the maximum potential prison time a director may receive resulting from a self-serving transaction that is neither disclosed nor approved. Executives face incentives and disincentives to manage earnings. We hypothesize and find a negative relation between potential prison time and earnings management. Further, we show that the negative relation between potential prison time and earnings management is stronger in countries where the population has more confidence in the court system. These findings suggest that potential prison time serves as a powerful disincentive to manage earnings.