Demand for the Truth in Principal-Agent Relationships
48 Pages Posted: 20 Jul 2006
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: Suggested Citation