The Agency Problems of Hedging and Earnings Management*

Abstract

This paper uses a principal-agent model to study the interaction between hedging and earnings management. Hedging makes earnings management more difficult and they appear to be strategic substitutes in this model, which is both consistent with existing empirical evidence and provides a new explanation for that evidence. If hedging decision is contractible, hedging is efficient since it reduces both the risk premium and the equilibrium amount of earnings management. If hedging decision is not contractible, however, hedging does not always alleviate the agency problem. Surprisingly, sometimes a scenario of no hedging but allowing earnings management is efficient. The reason is that motivating hedging may require a more costly compensation scheme to mitigate the appeal of earnings management. In addition, this paper shows that tolerating some earnings management is always efficient when there is no hedge option, since it is costly to eliminate earnings management. Sometimes it is inefficient to take any action against earnings management. However, with the encouraged hedge option, the cost to eliminate earnings management can be reduced significantly and zero tolerance of earnings management may be efficient.

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