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An optimal contracting approach to earnings management

Steven Huddart and Keith Crocker

We derive optimal contracts between a firm's shareholder and its privately-informed manager when the manager has the discretion to manipulate a public report of firm value by deferring or accelerating recognition of value. For low realizations of firm value, the manager overstates value in his report and for high realizations of firm value, he understates value. The distribution of reported value in the model has the key characteristic of the distribution of firms earnings reports noted in the empirical literature, namely a low frequency of earnings reports below a threshold and a high frequency at the threshhold. Moreover, the revision in price at the disclosure of the manager's report resembles the S-shaped price response noted in the empirical literature.

JEL Classification: J33 K22 M12

Keywords: accounting discretion, distortion, bonus compensation, earnings response coefficient, earnings management, hidden reserves, manipulation

this draft: August, 2006

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Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
huddart@psu.edu
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