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Demand for the Truth in Principal-Agent Relationships

Authors: Ronen, Joshua
Yaari, Varda
Keywords: Limited liability;Principal-agent contract;Report management;Revelation Principle
Issue Date: Jul-2006
Series/Report no.: Joshua Ronen-07
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 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.
Appears in Collections:Accounting Working Papers

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