Introduction to Earnings Management by Malek El Diri

Author:Malek El Diri
Language: eng
Format: epub
Publisher: Springer International Publishing, Cham

3.6 Conclusions

This chapter has established the theoretical framework for this book. Earnings management reflects the conflict of interests between the principal (shareholders) and the agent (managers), and thus the main theory that explains this phenomenon is the agency theory. Earnings management is the opposite of truth telling; hence there has to be a violation of the revelation principle for earnings management to occur. The violation may happen because of the costly contracting between the management and the shareholders based on contracting theory, the limitations in the abilities of the shareholders to understand management actions based on bounded rationality theory, and/or problems in communicating information to the shareholders based on information asymmetry theory.

There are no distinct boundaries between the previous theories as they might interact to determine earnings management behaviour. While complete contracting allows the shareholders to overcome some of their cognitive limitations in making decisions, the shareholders’ bounded rationalities contribute to establishing incomplete contracts. Similarly, information enables shareholders to improve their decisions but selecting the appropriate alternative depends on the abilities of the shareholders to understand and use information. Finally, while the degree of contract completeness influences the level of information asymmetry, the available information contributes to determining the structure of the contracts. The previous relations are depicted in Fig. 3.2.

Fig. 3.2The interaction between earnings management theories

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