On the Tension between Full Revelation and Earnings Management: A Reconsderation of the Revelation Principle

Abstract

The Revelation Principle throws a long shadow over the research on earnings management, because it states that whatever the equilibrium with earnings management is, there is no loss of generality in restricting the analysis to an equilibrium wherein the privately-informed players fully reveal the truth. We show that the research of earnings management must not be restricted to situations in which truth-telling, fully revealing equilibrium does not exist. The reason is that a game might have a plethora of truth-telling equilibriua, and to select the one that is likely to prevail requires finding first the equilibrum with earnings management, which is derived endogenously by the utility-maximizing players.

Keywords: revelation principle, earnings management, principal agent, communication

JEL Classification: D82, M40, M41, M43, M46