Management's reporting strategy and imperfection of the capital market

Abstract

Since the decision on the reported outcome is delegated to the management of the firm, it is commonly held that when the capital market is imperfect the manager achieves consumption smoothing by smoothing the reports relative to the actual outcome. Modeling the firm as a principal‐agent contract shows the contrary. When the capital market is imperfect the firm's reporting strategy is conservative, as the manager never reports more than the actual outcome because of fear of an unfavorable future outcome. When the capital market is perfect the firm either smooths the report‐reports more than the actual outcome when the actual outcome is low and reports less than the actual outcome when the outcome is hig‐or reports more than the actual outcome in order to take advantage of the sharing rule being an increasing function of the report.

Earning Management in Two-Period Principal-Agent Models

“…. In contrast to proposition 1 which can easily be 5 This contrasts Tzur/Yaari (1994), p. 60, who state that the manager always underreports in their scenario without memory. But as the wages of the first and second periods are not interrelated by the memory-(or a similar) condition, earnings management cannot have a systematic direction (in the sense of either under-or overreporing).…”

“…From the intention, Evans/Sridhar contrast a "truthful reporting" 4 with an "earnings management" regime, while this paper confronts the latter with a cash flow scenario. The contribution of Tzur/Yaari (1994) also leaves the reporting flexibility unrestricted. Furthermore, random outputs proxy for productive actions.…”

“…The agent's attempt to maximize compensation will be achieved by smoothing behaviour if the sharing rules of both periods have the same shape (reasonable assumption if preferences and production technology are similar in both periods).17 The deduction and result contrastTzur/Yaari (1994), p.60, who propose that the manager either smoothes or overreports.…”