Misreporting, Optimal Incentives, and Auditing

We propose a model that rationalizes the adoption of a misreporting system allowing managerial earning manipulation. A key element of our approach is the possibility of a tacit collusion between the board and the top management at the expense of shareholders and outside investors. Our framework predicts that the adoption of a misreporting system is mainly related to (i) the cost to the management of implementing such a system, (ii) the level of incentives and punishment the board faces, and (iii) the degree of independence/integrity of external auditors.