Demand for the Truth in Principal-Agent Relationships

48 Pages Posted: 20 Jul 2006

See all articles by Joshua Ronen

Joshua Ronen

New York University (NYU) - Department of Accounting

Varda Lewinstein Yaari

Multiple version iconThere are 2 versions of this paper

Date Written: July 2006


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 of the agent, defined as the agent's feasible minimum payment, might explain the demand for earnings management by the principal. Specifically, when the limited-liability 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.

Keywords: Earnings management, limited liability, principal-agent contract, revalation principle

JEL Classification: C73, D83, G30, M41, M43, M46, M49

Suggested Citation

Ronen, Joshua and Yaari, Varda Lewinstein, Demand for the Truth in Principal-Agent Relationships (July 2006). Available at SSRN: or

Joshua Ronen (Contact Author)

New York University (NYU) - Department of Accounting ( email )

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No contact information is available for Varda Lewinstein Yaari

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