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Demand for the truth in principal–agent relationships

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  • Joshua Ronen

    (New York University)

  • Varda (Lewinstein) Yaari

    (Morgan State University)

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.

Suggested Citation

  • Joshua Ronen & Varda (Lewinstein) Yaari, 2007. "Demand for the truth in principal–agent relationships," Review of Accounting Studies, Springer, vol. 12(1), pages 125-153, March.
    • Handle: RePEc:spr:reaccs:v:12:y:2007:i:1:d:10.1007_s11142-006-9021-0
    DOI: 10.1007/s11142-006-9021-0
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    References listed on IDEAS

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