Limited-Liability Contracts with Earnings Management

Numerous principal-agent situations of interest to accounting involve limited liability by the agent. We explore this issue when the outcome is mutually observable (MOC) and when it is not and the contract is based instead on the agent’s report (NCC). We find that when outcome is not observable, the effect of limited liability depends on the level of limited liability: when low – no effect; when medium – the principal fine-tunes payments based on a post-outcome imperfect public signal to compensate for the loss in flexibility caused by the agent’s limited liability; when high – the agent’s expected utility exceeds his reservation utility level and the public signal’s use is limited. Next, we invoke the revelation principle and examine an incentive compatible contract (RPC). Interestingly, RPC coincides with MOC when the limited liability is low and resembles NCC when limited liability is either medium or high. In addition, the impact of limited liability on the demand for earnings management is examined