Demand for the truth in principal-agent relationships

Joshua Ronen; Varda Yaari

doi:10.1007/s11142-006-9021-0

Demand for the truth in principal-agent relationships

Joshua Ronen, Varda Yaari

Research output: Contribution to journal › Article › peer-review

4 Scopus citations

Abstract

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 (LL) of the agent, defined as the agent's feasible minimum payment, might explain the demand for earnings management by the principal. Specifically, when the LL 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.

Original language	English
Pages (from-to)	125-153
Number of pages	29
Journal	Review of Accounting Studies
Volume	12
Issue number	1
DOIs	https://doi.org/10.1007/s11142-006-9021-0
State	Published - 1 Mar 2007
Externally published	Yes

Keywords

Limited liability
Principal-agent contract
Report management
Revelation principle

ASJC Scopus subject areas

Accounting
General Business, Management and Accounting

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10.1007/s11142-006-9021-0

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AB - 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 (LL) of the agent, defined as the agent's feasible minimum payment, might explain the demand for earnings management by the principal. Specifically, when the LL 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.

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Demand for the truth in principal-agent relationships

Abstract

Keywords

ASJC Scopus subject areas

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