Demand for the Truth in Principal-Agent Relationships
48 Pages Posted: 9 Oct 2008
There are 2 versions of this paper
Demand for the Truth in Principal-Agent Relationships
Date Written: July 2006
Abstract
Consider the following puzzle: If earnings management is harmful to shareholders, whydon'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 revealingcontract. This finding offers a new explanation of the demand for earningsmanagement.
Keywords: Limited liability, Principal-agent contract, Report management, Revelation Principle
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