________________________________________________________________________________________________________________________________________ D-CAF Working Paper No. 12 July 2006

D-CAF Working Paper Series ________________________________________________________________________________

Earnings Management, Leading Indicators, and Repeated Renegotiation in Dynamic Agency

P.O. Christensen, H. Frimor, and F. abac

EARNINGS MANAGEMENT, LEADING INDICATORS, ANDREPEATED RENEGOTIATION IN DYNAMIC AGENCY

Peter O. Christensen

University of Aarhus

Hans Frimor

University of Southern Denmark

Florin Sabac

University of Alberta

July 4, 2006

EARNINGS MANAGEMENT, LEADING INDICATORS, ANDREPEATED RENEGOTIATION IN DYNAMIC AGENCY

Abstract

Using a dynamic LEN model we show how renegotiation based on a non-contractible leading indi-

cator of a forthcoming performance measure introduces demand for discretionary accruals and equilib-

rium earnings management. In a setting with capital investments, we show how non-discretionary and

discretionary accruals combine to alleviate both commitment and induced moral hazard problems. In

particular, we show that depreciation policies that match both current cash receipts and the recognition

of future cash receipts solve the induced moral hazard problem. In contrast to existing literature, there

are several rounds of active renegotiation both due to lack of commitment and non-contractibility.

1 Introduction

Accounting researchers usually view reported earnings as being composed of cash flows and accruals, where

accruals are classified into non-discretionary and discretionary. Discussions of earnings quality typically

link the accrual component of earnings to the usefulness of earnings in forecasting and valuing firmsthe

valuation role of earnings. Earnings and their accrual component are relevant for contracting as well, and

here the valuation-driven ideas of earnings quality may be at odds with what would make earnings useful as

a performance measure for contracting, see Christensen, Feltham, and Sabac (2005)(CFS). While CFS only

examine the usefulness of non-discretionary accruals in contracting in a dynamic agency, we also examine

the discretionary component of accrualsearnings management.

We consider a true earnings measure, composed of cash flows and non-discretionary accruals, which

can be manipulated by the manager when he reports earnings. Thus, truthful reportingno earnings

managementconsists of reporting the true earnings measure. Earnings management is defined as the

extent to which the managers earnings report differs from true earnings, and it represents shifting of re-

ported income between periodsany under- or over-reporting by the manager in the first period is reversed

in the second period. In general, earnings management is not possible unless a full revelation mechanism

(the nemesis of earnings management research) is blocked by restricting either the contract space, the

message space, or possible commitments. Restricting the contract form is considered by Healy (1985) and

Chaney and Lewis (1995); restrictions on the message space by Dye (1988), and Demski (1998); and re-

strictions on commitment by Arya, Glover, and Sunder (1998), Demski and Frimor (1999), and Christensen,

Demski, and Frimor (2002).

1

We restrict contracts to be linear, we restrict communication to reported earnings, and we assume that

long-term contracts can be renegotiated. Thus, all assumptions of the revelation principle are violated,

and we view discretionary accruals as window dressing akin to Feltham and Xie (1994) and Dutta and

Gigler (2002), or income shifting as in Liang (2004). The principal controls the cost of earnings manage-

ment to the agent by controlling the tightness of auditing (compare Demski, Frimor, and Sappington 2004).

Auditing tightness ranges from allowing unrestricted earnings management on the agents part to restricting

it completely. The principal can costlessly preclude earnings management, but he may not find it optimal to

do so.

Distinguishing features of our paper are that we allow multiple rounds of renegotiationbefore and

after the agents earnings reportand that we examine the impact of the precision of information at the

first renegotiation encounter on earnings management. A leading indicator (such as an analyst earnings

forecast) is jointly observable before the first renegotiation encounter, yet it is non-contractible and not

directly under the agents control (by contrast, Dutta and Gigler 2002 introduce an earnings forecast by the

agent). Furthermore, the agents earnings management, as well as the precision of the leading indicator are

continuous variables that allow a more refined analysis of earnings management than the typically discrete

models employed in the earnings management literature (for example, see the comments of Lambert 1999).1

Allowing for multiple renegotiation encounters enables us to consider both renegotiation prior to a con-

tractible performance report as in Fudenberg and Tirole (1990) or Christensen, Demski, and Frimor (2002),

and renegotiation following a contractible performance report, as in Fudenberg, Holmstrm, and Mil-

grom (1990), and CFS. Furthermore, in our analysis, renegotiation is triggered by the release of information:

the non-contractible leading indicator triggers the first renegotiation, while the (manipulated) earnings re-

port triggers the second renegotiation. The leading indicator of true earnings is jointly observable and, thus,

the first renegotiation facilitates implicit contracting on this information as in Hermalin and Katz (1991).

When the leading indicator perfectly reveals the true performance measure, the second round of rene-

gotiation becomes irrelevant, and the model becomes similar to CFS (even though the leading indicator is

non-contractible). When the leading indicator is uninformative, the first round of renegotiation is similar

to the Fudenberg and Tirole (1990) type of renegotiation. Thus, varying the informativeness of the leading

indicator relative to the true performance measure allows us to bridge the gap between the two renegotiation

settings typically considered in the accounting literature.

1Liang (2004) also has continuous income shifting driven by differences in incentive rates across periods, but in a setting withfull commitment, where the differences in incentive rates are due to exogenously specified differences between the periods.

2

We describe conditions under which non-trivial earnings management is induced by the principal. A

first necessary condition is that the information revealed by the leading indicator is imperfect, so that the

subsequently reported performance measure is used for insurance purposes by the principal at the first rene-

gotiation stage. Without earnings management, anticipating this insurance motive for the principal at the

first renegotiation stage can create negative effort incentives in the first period if the performance reports in

the two periods are positively correlated. The second necessary condition is that the performance measures

in the two periods have sufficiently high correlation, so that the negative effort externality created by the

principals desire to provide insurance at the first renegotiation stage is sufficiently severe. The third con-

dition is that the signal-to-noise ratio of the leading indicator is small relative to the agents risk aversion.

All these conditions ensure that the insurance motive creates high renegotiation costs. Allowing earnings

management subsequent to the first renegotiation helps the principal commit not to be too aggressive in how

he provides insurancebig differences in incentives rates create strong incentives to shift income between

the two periods and, thus, high earnings management costs for the agent for which he must be compensated

ex ante.

In cases where the agent manipulates the earnings report, he always underreports, and the amount of

underreporting decreases in the precision of the leading indicator. At the same time, the principals expected

utility is increasing in the precision of the leading indicator, reflecting the lower costs of earnings manage-

ment and a lower risk premium for which the agent must be compensated. The precision of the leading

indicator impacts the optimal tightness of auditing in a more subtle way: there exists a cutoff valuewithin

the interval on which the signal-to-noise ratio of the leading indicator gives rise to non-trivial earnings

managementabove which the optimal tightness of auditing decreases in the precision of the leading indi-

cator.

A firms reported earnings are not only affected by the agents discretionary earnings management; they

are also affected by the accounting principles used, such as depreciation and revenue recognition policies,

which lead to non-discretionary accruals. We extend the model to include non-discretionary accruals by

considering a setting with a long-term investment decision in the first period. In addition to facilitating the

analysis of the impact of depreciation and recognition policies, this setting gives rise to an induced moral

hazard problem similar to that in Dutta and Reichelstein (2003). In this investment setting, we examine the