This paper uses a principal-agent model to study the interaction between hedging and earnings management. Hedging makes earnings management more difficult and they appear to be strategic substitutes in this model, which is both consistent with existing empirical evidence and provides a new explanation for that evidence. If hedging decision is contractible, hedging is efficient since it reduces both the risk premium and the equilibrium amount of earnings management. If hedging decision is not contractible, however, hedging does not always alleviate the agency problem. Surprisingly, sometimes a scenario of no hedging but allowing earnings management is efficient. The reason is that motivating hedging may require a more costly compensation scheme to mitigate the appeal of earnings management. In addition, this paper shows that tolerating some earnings management is always efficient when there is no hedge option, since it is costly to eliminate earnings management. Sometimes it is inefficient to take any action against earnings management. However, with the encouraged hedge option, the cost to eliminate earnings management can be reduced significantly and zero tolerance of earnings management may be efficient.

ABSTRACT We examine information quality and financial leverage when an entrepreneur needs financing to undertake a risky project and his effort input affects the project's outcome. We show that information quality and financial leverage interact to play active roles in both investment and effort decisions. Our analysis shows a positive association between leverage and optimal information quality—when leverage is low (high), low (high) information quality is optimal. This is because with low leverage, the entrepreneur is already motivated by his large share of the outcome to exert effort, and high information quality is not efficient as a precise bad signal discourages the entrepreneur's effort. In contrast, when leverage is high and thus the entrepreneur is less motivated by his residual cash flows, high information quality is optimal, because a precise good signal encourages the entrepreneur's effort. Our study highlights the joint effect of information quality and financial leverage on overall efficiency through firms' effort inputs as well as on defining investment efficiency.

ABSTRACT We investigate how incentives provided by whistleblowing programs affect the likelihood of whistleblowing, firm value, and social welfare in the presence of endogenous internal communication. Specifically, we focus on a myopic manager’s ex post decision on internal communication with the employee. An informed employee plays a dual role: working to fix the defect internally or acting as a whistleblower to expose the misconduct if the manager withholds defect information from the public. We find that, when the whistleblowing reward is relatively small, providing stronger incentives increases the likelihood of whistleblowing and can help improve firm value and social welfare. However, once rewards become excessively large and compromise internal communication, contrary to conventional wisdom, the likelihood of whistleblowing declines and both firm value and social welfare decline too. We also characterize the optimal whistleblowing rewards designed by strategic regulators seeking to maximize firm value or social welfare. JEL Classifications: D83; G30; G34; M40.