Earnings Management in an Overlapping Generations Model

In this paper, I propose and analyze two reasons shareholders might not be inclined to eliminate the tendency for managers to engage in earnings management. The first motive is related to the stewardship value of accounting information. Once shareholders have determined which productive act they seek their to implement, they must design a contract to encourage to select that action. If shareholders' sole objective in designing the contract is to minimize the expected cost of inducing managers to select their preferred action, and the expected cost-minimizing contract encourages earnings management, then an internal demand for earnings management exists. In contrast, shareholders are said to have an demand for earnings management if, holding managers' compensation and productive action fixed, they can improve their firm's contractual terms with outsiders by managing earnings. Though there are obviously several potential sources of such external demand (because of, e.g., accountingbased contracts with suppliers, debt-covenant restrictions, rate-of-return regulations), I analyze the external demand for earnings induced by current shareholders' attempts to alter prospective investors' perceptions of the firm's value.