News Management, Moral Hazard, and the Properties of Earnings, Prices, and Compensation

Abstract

I study theoretical properties of earnings, prices, and compensation by developing a dual moral hazard model in which a productive manager can selectively include verifiable information in an accounting report. When the cost of information is moderate, the solution exhibits several empirically-descriptive properties: market values exceed book values, the optimal earnings-based contract has a floor and a ceiling, the accounting system resembles historical cost with big bath write-downs but not write-ups, the Basu (1997) relation is conservative, the earnings distribution has a discontinuity, and the earnings-returns relation is S-shaped. These properties do not jointly emerge when the cost of information is low (high), in which case the accounting system resembles fair value (immediate expensing). I also show that the optimal earnings-based contract can always be replicated by a monotone price-based contract that may be implemented via performance shares.

Keywords: accounting; communication; contracting; agency theory; compensation; moral hazard

JEL Classification: D82, D83, D86, M12, M41, M52