Optimal contracts with intra-principal conflicts and the ubiquity of earnings management

N. K. Chidambaran, Bharat Sarath, Lingyi Zheng

Research output: Chapter in Book/Report/Conference proceedingChapter


The agency paradigm is primarily concerned with compensation contracts that align the interests of top management with those of shareholders, but such alignment may be imperfect. In particular, if shareholders differ in their time-preferences, it will be impossible to find a contract that fully aligns manager interests with those of both long-term and short-term shareholders. In this study, we examine the relationship between the inter-temporal weighting on a CEO’s contract and shareholder welfare in a setting where shareholders liquidate choose to cash in their holdings in different time-periods. We show that the managerial compensation contract will typically create incentives for the manager to trade-off short-term price increases with long-term value creation and it is possible to design a second-best contract that is Pareto optimal. This analysis shows that the impact of earnings management is often mischaracterized as Pareto suboptimal even though it may be a requisite to make both long and short-term shareholders better-off on average.

Original languageEnglish (US)
Title of host publicationBehavioral Finance
Subtitle of host publicationA Novel Approach
PublisherWorld Scientific Publishing Co.
Number of pages20
ISBN (Electronic)9789811229251
StatePublished - Jan 1 2020

All Science Journal Classification (ASJC) codes

  • Economics, Econometrics and Finance(all)
  • Business, Management and Accounting(all)


  • Compensation duration
  • Investment distortions
  • Investor horizon
  • Myopia
  • Real earnings management


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