Earnings Management and the Revelation Principle

Abstract

Abstract. When the Revelation Principle (RP) holds, managing earnings confers no advantage over revelation. We construct an explanation for earnings management that is based on limitations on owners ’ ability to make commitments (a violation of the RP’s assumptions). Traditionally, earnings management is seen as sneaky managers pulling the wool over the eyes of gullible owners by manipulating accruals; our limited commitment story suggests that the owners, too, can benefit from earnings management. We categorize a variety of extant explanations of earnings management, along with our own, according to which of the assumptions of the RP each explanation violates. Plausibility of multiple simultaneous violations of the assumptions, and strategic use of various accounting and real instruments of earnings management, complicate the task of detecting such management in field data. When managers choose accounting accruals, neutral communication of the firm’s underlying economic reality to the readers of financial reports is not necessarily their only goal. This goal can become enmeshed with managers ’ desire to use financial reports, especially earnings, opportunistically to serve their own personal ends. The existence of such mixed motives in managers has given rise to hypotheses about management (or manipulation) of earnings, theoretical analyses of the interaction between the two motives for such management,

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