Earnings Management, Fintech-Driven Incentives and Sustainable Growth

On Complex Systems, Legal and Mechanism Design Factors

Michael I. C. Nwogugu

• Publisher: Routledge
• Year: 2019
• Print ISBN: 9781409456964
• eBook ISBN: 9781317146551
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Traditional research about Financial Stability and Sustainable Growth typically omits Earnings Management (as a broad class of misconduct), Complex Systems Theory, Mechanism Design Theory, Public Health, psychology issues, and the externalities and psychological effects of Fintech. Inequality, Environmental Pollution, Earnings Management opportunities, the varieties of complex Financial Instruments, Fintech, Regulatory Fragmentation, Regulatory Capture and real-financial sector-linkages are growing around the world, and these factors can have symbiotic relationships. Within Complex System theory framework, this book analyzes these foregoing issues, and introduces new behaviour theories, Enforcement Dichotomies, and critiques of models, regulations and theories in several dimensions. The issues analyzed can affect markets, and evolutions of systems, decision-making, "nternal Markets and risk-perception within government regulators, operating companies and investment entities, and thus they have Public Policy implications. The legal analysis uses applicable US case-law and statutes (which have been copied by many countries, and are similar to those of many common-law countries).

Using Qualitative Reasoning, Capital Dynamics Theory (a new approach introduced in this book), Critical Theory and elements of Mechanism Design Theory, the book aims to enhance cross-disciplinary analysis of the above-mentioned issues; and to help researchers build better systems/Artificial-Intelligence/mathematical models in Financial Stability, Portfolio Management, Policy-Analysis, Asset Pricing, Contract Theory, Enforcement Theory and Fraud Detection.

The primary audience for this book consists of university Professors, PHD students and PHD degree-holders (in industries, government agencies, financial services companies and research institutes). The book can be used as a primary or supplementary textbook for graduate courses in Regulation; Capital Markets; Law & Economics, International Political Economy and or Mechanism Design (Applied Math, Operations Research, Computer Science or Finance).

1

Introduction¹

Earnings management and the efficiency of Incentive Mechanisms and Fintech (and their significant impact on economic planning/modelling, public policy and quality of life) remain significant problems in both developed and developing economies around the world; and have substantial implications for sustainability (economic, social, urban and environmental sustainability), economic growth, risk regulation, risk management, systemic risk and financial stability; all of which affect pension plans, household wealth and government policies. Unfortunately, legislatures and the executive branches of government and the judiciaries in most countries have not been able to properly address this problem. Most regulations that were intended to reduce earnings management and or improve the efficiency of Incentive Mechanisms and Fintech have been ineffective or costly to implement. The nature, evolution and psychological effects of associated Incentive Mechanisms and Fintech (for both individuals and corporate entities) have become dominant institutions that affect sustainability, risk-taking and risk management.

This book differs from all other books on Earnings Management, Inequality and Sustainable Growth in the following ways:

1. i) The approaches used include “Qualitative Reasoning” (see: Forbus (2019), Halpern (2003), and Bredeweg and Struss (Winter 2003)), Critical Theory, “Capital Dynamics Theory” (introduced in this book), Mechanism Design and Complex Systems Theory.
2. ii) This book introduces “Asset-Quality Management ” and Incentive-effects Management as distinct classes of actionable Disclosure-Misconduct (civil and or criminal liability) or ethics violations (some of which were formerly bundled together as “Earnings Management ”).
3. iii) This book does not focus on specific types and instances of earnings management, but rather, focuses on behavioral biases, and the Incentive Mechanisms and institutions that can facilitate Earnings Management and Incentive-effects Management (as broadly defined), Inequality and Fintech Gaps (explained herein and below); and or affect Sustainable Growth, Enforcement and “Capital Dynamics Theory ”. This book addresses the behavioral effects of accounting rules and the auditee-firms’ and auditors’ Group Decisions (causes and effects) that pertain to Disclosure-Misconduct within the context of the firm, regulatory regimes and sustainability – all of which often have Multiplier Effects. Collectively, such analysis can help improve Computer Science, Physics, Decision Sciences and Artificial Intelligence models that are used to identify or predict financial statement fraud, Corporate Bankruptcy and or Non-Compliance, and to model Portfolio Management, Financial Stability, Asset Pricing, Household Dynamics/Allocations, Consumer Behavior, Retailing Trends, “Personal Growth”, Organizational Psychology trends, International Contagion (of Cultures, Beliefs, Usage-of-Trade, technologies, market-volatility, Corporate Governance; enforcement patterns; etc.), and Public Policy.
4. iv) Various parties have estimated that more than 80 percent of all equity and futures trading in the USA and perhaps other countries is now automated/algorithmic²; and one implication is that most “traditional” research on Market Microstructure, Risk-Perception, Household dynamics/allocations, Preferences and Reasoning is misleading or incomplete. This book helps in bridging that gap.
5. v) This book addresses the efficiency of regulations that affect the incentives (of firms, employees; and auditors) to perpetrate Earnings Management, Incentive-effects Management and or Asset-Quality Management.
6. vi) The book addresses the macroeconomic, Public Health and International Political Economy dimensions of Earnings Management, Asset-Quality Management and Incentive-Effects Management – including Inequality and Environmental Auditing.
7. vii) The book introduces Economic Psychology and “Behavioral Operations Research” theories that pertain to two classes of assets that generate or can generate more than 60 percent of all earnings management and asset quality management and substantial Sustainability problems, and ironically also generate a substantial portion of economic growth in many developed countries – which are Intangible Assets and Real Estate. The book analyzes issues in the Global Real Estate Markets and the Global Intangibles Economy that related to Antitrust, Group Decisions, Behavioral Biases, Consumer Behavior, and the efficiency of Incentive Mechanisms.
8. viii) The book addresses Earnings Management, Asset-Quality Management and Incentive-Effects Management and their “Multiplier Effects” in developing countries and Less-Developed Countries.
9. ix) The book addresses critical issues that pertain to Trust, Perception and Cooperation in markets, and to Preferences, Beliefs and Reasoning (all of which are widely debated in HCI, Fintech and AI).
10. x) From Mechanism Design, Contract Theory, Dynamical Systems, Sustainability and Complex Systems Theory perspectives, this book addresses the following classes of issues:
    1. 1) Multi-sided Incentives that can reduce or increase earnings management, asset-quality management, sustainability and incentive-effects management – such as Incentives, Fintech and ARS auctions. Such incentives actively involve two or more persons or classes of persons.
    2. 2) “Many-person Re-generative Institutions” such as Intangibles/Goodwill accounting rules; Fintech, AI, legal processes; etc.
    3. 3) “Many-person Mechanisms” that affect behaviors of Human/Automated Agents and can reduce or increase harmful group collusion, and the incentives for transparency and truthfulness.
    4. 4) The elicitation of: i) “best” preferences for organizations; ii) preferences of groups in organizations.
    5. 5) Complex adaptive systems.

Earnings Management, Incentive-Effects Management, violations of Securities Laws and associated Multiplier Effects (economic, psychological, political, social, contagion and capital markets) have been analysed from various perspectives including the following:

1. i) Psychology (Economic Psychology and Organizational Psychology) and Consumer Behavior.
2. ii) Retailing – e.g. Retail financial services; franchising; Household Dynamics/Allocations; etc.
3. iii) Telecommunications and Networks – e.g. contagion in online social networks; investor networks; etc.
4. iv) Corporate Finance – see: Agrawal and Cooper (2017).
5. v) Financial Engineering – see: Kamran, Zhao, Ali and Sabir (2018).
6. vi) Management-Science – see: Chapman and Steenburgh (2010) and Chen, Wu, et al. (2017).
7. vii) Operations-Research (Fintech and Artifical Intelligence) – see: Königsgruber and Palan (2015); Koskivaara (2000) and Calvo, Ivorra and Liern (2017).
8. viii) Applied Math, Decision Sciences and Artifical Intelligence – see: Zhou and Kapoor (2011); Dbouk and Zaarour (2017); Dikmen and Kukkocaoglu (2010) and Ngai, Hu, et al. (2011).
9. ix) Computer Science (Fintech and Artifical Intelligence) – see: Long, Song and Cui (2017) and Trigo, Belfo and Estébanez (2016).
10. x) Political Geography – see: Gross et al. (2016).
11. xi) Political Economy – see: Ding, Li and Wu (2018); Abeysekera (2003); Boczko (2000) and Gross, Königsgruber, et al. (2016).
12. xii) Physics – see: Ma, Zhuang and Li (2011); Battiston and Glattfelder (2009); Kuzubas, Ömercikoglu and Saltoglu (2014) and Li, An, Gao, et al. (2014).
13. xiii) Game Theory (Math) – see: Shuotong and Yanxi (2012).
14. xiv) Public Policy – see: Gross, et al. (2016).
15. xv) Economics – see: Marinovic (2013) and Cumming and Johan (2013).
16. xvi) Finance (Bankruptcy Prediction, Portfolio Management and Asset Pricing) – see Veganzones and Severin (June 2017); Drabkova (2016); Kwag and Stephens (2009) and Sun (2009).
17. xvii) Corporate Governance – see Badia, Dicuonzo, et al. (2019) and Zambon, Marasca and Chiucchi (2019).
18. xviii) Law – see: Ma (2013).
19. xix) Accounting Information Systems – see: Chen, Wu, et al. (2017).

The common elements among these approaches are as follows: i) Networks; ii) public policy; and iii) relationships between corporate financial policies and capital markets dynamics; and iv) identification of patterns of misconduct. However, most of these studies: i) don’t distinguish among Earnings Management, “Asset-Quality Management ” and “Incentive-Effects Management ”; and or don’t analyze asset-quality management and Incentive-Effects Management; ii) don’t analyze the Public Health, Inequality and other macroeconomic implications of such misconduct; iii) don’t analyze affected institutions and Incentive Mechanisms; and iv) don’t analyze Contract Theory issues.

Earnings management, Asset-quality Management and Incentive-Effects Management typically occur and or are amplified within the context of, and often distort organizations, Incentive-Mechanisms, Contracting-Frameworks, Networks-of-Contracts, markets and benefits of Fintech. Contract Theory and Mechanism Design Theory have been jointly studied from various perspectives including Economics/Finance, Operations Research, Mathematical Psychology, Computer Science, Game Theory and Applied Math – see: Hoppe and Schmitz (2018); Niederhoff and Kouvelis (2019); Hong, Wernz and Stillinger (2016); Wu, Zhao and Tang (2014); Li, Liu and Chen (2018); Lin and Chou (1990); Park and Kim (2014); Goetz et al. (2019); Fang and Yuan (2018); Madureira et al. (2014); Meneguzzi et al. (2011, 2012); Zohar and Rosenschein (2008); Terán, Aguilar and Cerrada (2017); and Wei et al. (2018). However, the models in most of these foregoing articles and literature are static, don’t incorporate relevant variables; don’t consider varying “states” and often complex “joint” effects of variables; and they don’t consider Industrial Organization effects of contracts/mechanisms – see Nwogugu (2007a;b), Nwogugu (2019a;b) and Nwogugu (2006).

Various types of Inequality have been analyzed from Physics, Applied Mathematics, Taxation, Econometrics and Economics perspectives (with the common themes being Networks, transactions and wealth-concentration), and the associated literatures are cited in Chapter 3 in this book.

With regards to Public Policy and affected populations, the theories introduced and issues analyzed in this book collectively (and directly or indirectly) affect more than two billion people in several continents; and more than €310 trillion of corporate, government and household assets; and more than €10 trillion of daily transactions around the world (e.g. loans/bonds/notes; money-markets; stock markets; swaps/derivatives; Structured Products; commodities; credit transactions; Equity-Based Incentives (EBIs) and employee incentives; employee costs/taxes; performance benchmarking; etc.).

The primary audience for this book is as follows:

1. i) University professors.
2. ii) PhD-degree-holders who work in industry, think-tanks, consulting firms, financial services companies and government agencies.
3. iii) PhD students.

The book can also be used as a primary or supplemental textbook for graduate courses in Behavioral Operations Research; Risk Management; Applied Mathematics; Complex Adaptive Systems; Behavioral Political Economy; Accounting; Law & Economics; Mathematical Psychology and Organizational Psychology.

In some chapters in this book, “Incentive Mechanisms” and Game-Theory Models are introduced or discussed (by explaining how they function). These are in the nature of one or more of the following:

1. i) Game-Theory strategies – similar to how Supermodularity and Complementarity can be represented by ∂²f/∂z_i∂z_j ≥ 0; for all i ≠ j; where and z_i and z_j are strategies of participants in the action space and each action is chosen from an interval z_i, z_j ɛ [a,b]; and the payoff function (f(.)) depends on actions/strategies of two or more types of participants z_i and z_j in the action space (i = 1… … . . n; j=1… …… n).
2. ii) Invariants – which are used to characterize key elements of Groups.
3. iii) Decision elements – wherein groups of these “mechanisms” can also be weighted and converted into decision-scores for decision making.
4. iv) Dynamical Systems elements.

1.1 “Capital dynamics theory”

“Capital Dynamics Theory” is a new approach introduced herein, and it relates corporate financial policies, Behavioral Operations Research, Game-Theory type analysis of Managerial Risk Preferences, Contract Theory, “Accounting Biases” and Earnings Management on one hand, to Sustainable Growth, Fintech-Gaps, AI, Financial Stability, Complex Systems Theory and capital markets. Fintech-Gaps consists of the psychological effects of Fintech and associated Artificial Intelligence, inefficiencies inherent in the use of Fintech/AI, “Fintech/AI Externalities”, and Externalities that can affect Fintech.

Capital Dynamics Theory introduces “Asset-Quality Management” and Incentive-Effects Management as distinct classes of actionable Disclosure-Misconduct (civil and or criminal liability) or ethics violations, some of which were formerly bundled together as “Earnings Management”; and as distinct types of Incentive-Mechanisms and Disclosure-Misconduct that can affect macroeconomic/macrofinancial and political trends and human psychology – that is the “Three-Factor Evolution Model”, an Emergent phenomena.

Capital Dynamics Theory analyzes the Public Health, Environmental Pollution, Inefficient Resource Allocation and Inequality (the “Four-F...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Contents
• 1 Introduction
• 2 Complex adaptive systems, enforcement theory, and applicability of real options theory to the selection of disputes (accounting regulations and securities laws) for litigation
• 3 Industry 5.0/6.0: some public health, inequality, environmental pollution and inefficient resource-allocation implications
• 4 Fintech-based disclosure and incentives-effects misconduct as macrofinancial and international political economy leakages: sustainable growth and financial stability
• 5 Complex adaptive systems, sustainable growth and securities law: on inequality, preferences+reasoning and the optimal design of financial contracts
• 6 Mechanism design theory, public health and Preferences+Beliefs: behavioral biases and structural-effects inherent in reits, “recs” and “pics”
• 7 The Global Intangibles+Digital Economy, sustainability and public health: on Preferences+Beliefs and intangibles accounting regulations as fintech-driven incentive mechanisms
• 8 Economic policy, sustainability and fintech-driven decisions: Chinese vies and Chinese reverse-merger companies contradict mechanism-design theory, contract theory and asset-pricing theory