Demand for the truth in principal–agent relationships

Demand for the truth in principal–agent relationships Consider the following puzzle: If earnings management is harmful to shareholders, why don’t they design contracts that induce managers to reveal the truth? To answer this question, we model the shareholders–manager relationship as a principal–agent game in which the agent (the manager) alone observes the economic outcome. We show that the limited liability (LL) of the agent, defined as the agent’s feasible minimum payment, might explain the demand for earnings management by the principal. Specifically, when the LL level is high (low), a contract that induces earnings management may be less (more) costly than a truth-revealing contract. This finding offers a new explanation of the demand for earnings management. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Accounting Studies Springer Journals

Demand for the truth in principal–agent relationships

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Publisher
Kluwer Academic Publishers-Plenum Publishers
Copyright
Copyright © 2007 by Springer Science+Business Media, LLC
Subject
Business and Management; Accounting/Auditing; Corporate Finance; Public Finance
ISSN
1380-6653
eISSN
1573-7136
D.O.I.
10.1007/s11142-006-9021-0
Publisher site
See Article on Publisher Site

Abstract

Consider the following puzzle: If earnings management is harmful to shareholders, why don’t they design contracts that induce managers to reveal the truth? To answer this question, we model the shareholders–manager relationship as a principal–agent game in which the agent (the manager) alone observes the economic outcome. We show that the limited liability (LL) of the agent, defined as the agent’s feasible minimum payment, might explain the demand for earnings management by the principal. Specifically, when the LL level is high (low), a contract that induces earnings management may be less (more) costly than a truth-revealing contract. This finding offers a new explanation of the demand for earnings management.

Journal

Review of Accounting StudiesSpringer Journals

Published: Feb 27, 2007

References

  • Earnings management and the revelation principle
    Arya, A.; Glover, J. C.; Sunder, S.

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