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Optimal Contracts with Intra-Principal Conflicts and the Ubiquity of Earnings Management

In: Behavioral Finance A Novel Approach

Author

Listed:
  • N. K. Chidambaran
  • Bharat Sarath
  • Lingyi Zheng

Abstract

The agency paradigm is primarily concerned with compensation contracts that align the interests of top management with those of shareholders, but such alignment may be imperfect. In particular, if shareholders differ in their time-preferences, it will be impossible to find a contract that fully aligns manager interests with those of both long-term and short-term shareholders. In this study, we examine the relationship between the inter-temporal weighting on a CEO’s contract and shareholder welfare in a setting where shareholders liquidate choose to cash in their holdings in different time-periods. We show that the managerial compensation contract will typically create incentives for the manager to trade-off short-term price increases with long-term value creation and it is possible to design a second-best contract that is Pareto optimal. This analysis shows that the impact of earnings management is often mischaracterized as Pareto suboptimal even though it may be a requisite to make both long and short-term shareholders better-off on average.

Suggested Citation

  • N. K. Chidambaran & Bharat Sarath & Lingyi Zheng, 2020. "Optimal Contracts with Intra-Principal Conflicts and the Ubiquity of Earnings Management," World Scientific Book Chapters, in: Itzhak Venezia (ed.), Behavioral Finance A Novel Approach, chapter 13, pages 303-322, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789811229251_0013
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    Keywords

    Analysts Recommendations; Behavioral Biases; Behavioral Economics; Behavioral Finance; Board of Directors ; Compensation; Compensation Committee; Control; Coronavirus; Corporate Governance; COVID-19; Decision Making; Disposition Effect; Earnings Management; Elections; Emotions; Financial Crises; Financial Market Anomalies; Financial Markets; Forecast-Accuracy; Gender Differences; Heuristics; Interval Forecasting; Investment; Investor Horizon; Investors' Beliefs; IPO Under-Pricing; Life Expectancy; Myopia; Overconfidence; Pensions Industry; Policy Reforms; Polls; Portfolio Risk; Prediction Markets; Regulation; Stock Price Drifts; Time Preferences;
    All these keywords.

    JEL classification:

    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets
    • G4 - Financial Economics - - Behavioral Finance
    • G3 - Financial Economics - - Corporate Finance and Governance
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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