Incentives and penalties related to earnings overstatements that violate GAAP

This paper investigates the incentives and the penalties related to earning s overstatements primarily in firms that are subject to accounting enforcem ent actions by the Securities and Exchange Commission (SEC). I find (1) tha t managers in treatment firms are more likely to sell their holdings and ex ercise stock appreciation rights in the period when earnings are overstated than are managers in control firms, and (2) that the sales occur at inflat ed prices. I do not find evidence that earnings overstatement in these firm s is motivated by concerns about debt covenant violations or the cost of ex ternal financing. The evidence suggests that the monitoring of managers' tr ading behavior can be informative about the likelihood of earnings overstat ement. Many economists believe that insider trading is an efficient method of comp ensating managers for their efforts. These economists argue that reputation losses would preclude managers from making profitable trades before period s of poor corporate performance. Consequently, this paper also investigates the employment and monetary penalties imposed on managers after the earnin gs overstatement is publicly discovered. This evidence reveals that (1) man agers' employment losses subsequent to discovery are similar in firms that do and do not overstate earnings and (2) that the SEC is not likely to impo se trading sanctions on managers in firms with earnings overstatement unles s the managers sell their own shares as part of a firm security offering. T he evidence suggests that neither employment or SEC-imposed monetary losses are effective in preventing the managers in these firms with extreme earni ngs overstatements from selling their stake in their firms in the face of d eclining performance.