Journal of Accounting Research

Vol. 40 No. 3 June 2002

Printed in U.S.A.

The Effect of Earnings Forecasts

on Earnings Management
S U N I L D U T T A ∗ A N D F R A N K G I G L E R†

Received 16 May 2000; accepted 24 January 2002

ABSTRACT

We develop a theory of the association between earnings management and

voluntary management forecasts in an agency setting. Earnings management
is modeled as a “window dressing” action that can increase the firm’s reported
accounting earnings but has no impact on the firm’s real cash flows. Earnings
forecasts are modeled as the manager’s communication of the firm’s future
cash flows. We show that it is easier to prevent the manager from managing
earnings if he is asked to forecast earnings. We also show that earnings man-
agement is more likely to follow high earnings forecasts than low earnings
forecasts. Finally, our analysis shows that shareholders may not find it optimal
to prohibit earnings management. Earlier results rationalize earnings manage-
ment by violating some assumption underlying the Revelation Principle. By
contrast, in our model the principal can make full commitments and commu-
nication is unrestricted. Nonetheless, earnings management can be beneficial
as it reduces the cost of eliciting truthful forecasts.

1. Introduction
This paper examines the effects of management forecasts on the extent
of earnings management. The phenomenon of earnings management has
received considerable attention in both theoretical and empirical academic

∗ University of California, Berkeley; †Northwestern University. We wish to thank Tim

Baldenius, Joel Demski, Ronald Dye, Thomas Hemmer, Arijit Mukherji, Brett Trueman,
Amir Ziv, participants in the University of Minnesota 2000 accounting theory mini-conference,
the 2001 Berkeley Accounting Research Talks, the UCLA accounting workshop and the 2001
Columbia University Business School’s Burton Workshop for their comments.

631
Copyright 
C , University of Chicago on behalf of the Institute of Professional Accounting, 2002
632 S . DUTTA AND F . GIGLER

research. A number of empirical studies have attempted to detect and docu-

ment earnings management and study the extent to which this phenomenon
is influenced by market expectations.1 One of the specific conclusions aris-
ing from these studies is that earnings tend to be managed toward expecta-
tions in general and toward earnings forecasts in particular. The theoretical
literature has primarily focused on identifying conditions under which earn-
ings management emerges as an optimal strategy in either a contracting or
market setting.2 However, to date there has been no theoretical analysis of
the interaction between voluntary management forecasts and the extent of
earnings management.
We develop a theory of the association between earnings management
and voluntary management forecasts using an agency setting to represent
the relationship between a firm’s shareholders and its manager. Earnings
management is modeled as a “window dressing” action undertaken by the
manager. While such a nonproductive action can increase the firm’s re-
ported accounting earnings, it has no impact on the firm’s real cash flows
or economic earnings. The firm’s economic earnings depend on the man-
ager’s choice of productive efforts. Earnings forecasts are modeled as the
manager’s communication to the firm’s shareholders about the firm’s eco-
nomic earnings.
When the manager is not asked to provide an earnings forecast, produc-
tive effort incentives require that the manager’s compensation be increasing
in reported accounting earnings. But such a contingent contract tempts the
manager to engage in unproductive earnings management. However, when
the manager is asked to make an earnings forecast, communication of his
private information expands the set of contractible variables to include the
forecasts as well as the reported accounting earnings. This increases the pa-
rameter space over which the manager can be prevented from engaging in
unproductive earnings management (and yet induced to provide produc-
tive effort), a prediction seemingly at odds with conventional wisdom that
earnings management is more prevalent following earnings forecasts.
The notion that managers have incentives to manage earnings toward
earnings forecasts is commonly based on the argument that managers are
likely to face negative consequences for missing explicit forecasts or implicit
expectations. Arguing that the costs of missing forecasts are likely to be
higher for overestimates than for underestimates, Kasznik [1999] hypothe-
sizes that earnings are more likely to be managed following a high forecast
than following a low forecast. Using accruals to measure earnings manage-
ment, he finds support for his hypothesis that managers face asymmetric
incentives for earnings management.
Interestingly, our model also predicts that the shareholders will optimally
induce the manager to engage in asymmetric earnings management. In

1 See, for instance, Hayn [1995], Burgstahler and Dichev [1997], and Kasznik [1999].
2 See Dye [1988], Evans and Sridhar [1996], Demski [1998], Arya, Glover, and Sunder
[1998], and Demski and Frimor [1999].
 THE EFFECT OF EARNINGS FORECASTS 633

contrast to the arguments based on exogenous legal or reputation con-

cerns, however, our optimal contracting framework identifies an endoge-
nous benefit of voluntary forecasts to shareholders in deterring earnings
management and an endogenous cost to the manager of missing a forecast.
We find that while it is always feasible and optimal to deter earnings man-
agement contingent on a low forecast, under certain circumstances it may
be necessary and optimal to tolerate earnings management contingent on
a high forecast. Furthermore, the optimal contract is always such that the
manager is penalized for missing a high forecast but not for missing a low
forecast. Consequently, our analysis establishes that managers may be opti-
mally offered asymmetric incentives to manage earnings.
As a managerial performance measure, we find that such “conditionally”
managed earnings are always more efficient than unmanaged earnings. The
reason is that when the earnings are selectively managed in the high state,
it becomes easier to elicit a truthful forecast from the manager in the low
state. Nonetheless, we find that it is not always optimal to induce conditional
earnings management of this form. This is a consequence of the fact that
inducing conditional earnings management imposes costs of its own. In
addition to paying the manager’s direct personal cost, the shareholders
may have to pay a higher risk premium because the optimal contract may
have to entail more risk in order to “induce” earnings manipulation.
The first part of our analysis focuses on the choice of the optimal level and
type of earnings management for a given earnings management technology.
We next consider the shareholders’ preferences over accounting and au-
diting standards, as they may be used to control the level of difficulty the
manager faces in managing earnings. Our analysis shows that, for a large
class of parameters, the shareholders would not find it optimal to design an
overly restrictive accounting and auditing system. The key for this result is
our earlier observation that it is more efficient to provide productive effort
incentives through conditionally managed earnings than through unman-
aged earnings. A sufficiently lax accounting and auditing regime ensures
that the incentive contracting benefits of earnings management outweigh
the direct and indirect costs of inducing earnings management.
Previous theories of earnings management have primarily modeled “re-
ported earnings” as a message used by management to communicate their
private information about “true earnings” to shareholders in principal-agent
settings.3 Earnings management is said to take place when the reported
earnings differ from the true earnings; that is, when the agent dishon-
estly communicates his private information. Such a strategy will be optimal
only when the Revelation Principle fails to hold.4 Dye [1988], Evans and

3 See Trueman and Titman [1988] for a model of earnings management in a “market” setting

where the sender of the information (the firm) does not have an explicit contract with the
receivers of the information (potential investors).
4 In this regard, Dye [1988, page 200] observes that “when the manager can communicate

all dimensions of his private information to shareholders, the Revelation Principle does indeed
apply, and so no internal demand for earnings management exists.”
634 S . DUTTA AND F . GIGLER

Sridhar [1996], and Demski [1998] focus on settings in which the Revela-
tion Principle fails because the agent is unable to perfectly communicate his
private information. Arya, Glover, and Sunder [1998], Demski and Frimor
[1999], and Christensen, Demski, and Frimor [2001] examine models in
which the Revelation Principle fails because of the principal’s inability to
commit.
In contrast to the above models, we follow the approach taken by Feltham
and Xie [1994] in modeling earnings management as a form of window
dressing action. Accounting earnings are viewed as a result of potentially two
types of managerial actions: a productive action that affects true economic
earnings as well as reported accounting earnings, and window dressing ac-
tion that affects reported earnings without changing true economic earn-
ings. Earnings management is said to occur when the manager chooses to
influence the reported earnings by taking the nonproductive window dress-
ing action. To this framework we add the agent’s private information about
economic earnings and his ability to communicate it through earnings fore-
casts. Similar to the agency models of Christensen [1981] and Dye [1983],
the truthful revelation of the self-reported information (earnings forecasts)
is enforced through a correlated public signal (accounting earnings). In our
context, as in Gigler and Hemmer [1998], the reported accounting earnings
thus serve a confirmatory role in disciplining the manager’s earnings fore-
casts. This modeling approach has two distinct advantages: first, it allows us
to examine the impact of management forecasts on the extent of earnings
management, and second it does not require violation of the Revelation
Principle in order to generate a demand for earnings management.
The remainder of our paper is organized as follows. Section 2 provides the
basic model. Section 3 characterizes the regions in which it is feasible to eli-
minate earnings management with and without earnings forecasts. Section 4
examines the shareholders’ optimal choice of earnings management for a
given accounting/auditing regime. Section 5 examines the shareholders’
preferences over accounting/auditing regimes. Section 6 provides a short
summary and conclusion. The proofs of all results presented in the body of
the paper are contained in appendix.

2. Basic Setup
We consider an ongoing firm that requires an agent (manager) to man-
age its operations. The firm’s shareholders contract with the manager. The
manager contributes an unobservable productive input a to enhance the
firm’s output x, which is referred to as economic earnings. To focus on
the main issue, we consider a simple setup in which managerial actions
as well as informational variables are binary. In particular, we assume that
a ∈ {al , ah } and x ∈ {x L , x H }.5 We refer to the action ah (al ) as high (low)

5 We will follow the convention of labeling choice variables with lower case subscripts and

the realization of random variables with upper case subscripts.

 THE EFFECT OF EARNINGS FORECASTS 635

effort, and to the output x H (x L ) as high (low) economic earnings. High

effort is more productive in the sense that Pr(x H | ah ) > Pr(x H | al ). For
brevity, we use ph and pl to denote Pr(x H | ah ) and Pr(x H | al ) respectively.
To ensure a fixed support, we assume that ph < 1.
The manager privately observes economic earnings x in the current pe-
riod. The shareholders, however, observe x directly only after the manager’s
contracting horizon has expired. Consequently, economic earnings x can-
not be used for contracting purposes.6 For contracting purposes, the par-
ties rely on the end of the period accounting earnings report y , where
y ∈ {y L , y H }. For simplicity and without loss of generality, we normalize ac-
counting and economic earnings to have the same support, that is y L = x L
and y H = x H . However, due to measurement errors to be introduced later,
accounting income provides only a noisy estimate of the underlying eco-
nomic income.
A key feature of our model is that the manager can engage in “perfor-
mance manipulation” activities that increase the likelihood of high account-
ing earnings. As an example, the manager could exert efforts to accelerate
(or decelerate) the delivery of services or goods near the end of the period
in an attempt to move earnings toward his earlier forecast. The manager de-
cides whether to engage in such performance management activities after
observing the firm’s economic income. The manager’s choice of manipula-
tive action conditional on his observation of economic income is denoted
by m(x), where m(x) ∈ {0, 1} and m(x) = 1 (m(x) = 0) denotes the case
when the manager engages (does not engage) in earnings management.
The technology satisfies the following independence assumption:
Pr (x,y | a, m(x)) = Pr (x | a) · Pr (y | x, m(x)). (1)
Thus, the manager’s choice of m does not impact the current period’s out-
put x. Furthermore, the manager’s choice of productive action a affects
accounting earnings only through its effect on the output x.
For each m(x) ∈ {0, 1}, let λ Hm denote the probability of high account-
ing income conditional on high economic income and choice of m, i.e.,
λ Hm ≡ Pr(y H | x H , m(x H )). Similarly, let λ Lm denote the probability of high
accounting income conditional on low economic income and choice of m,
i.e., λ Lm ≡ Pr(y H | x L , m(x L )).7 To ensure a greater likelihood of high ac-
counting income when either economic income is high or the manager

6 As discussed later, however, the manager’s contract can be made contingent on his report

about the underlying economic earnings. This setting is a derivative of Dye’s [1983] post-
decision information model.
7 A potentially important characteristic of managing earnings through discretionary accruals

is that discretionary accruals reverse. This feature cannot be captured in our one period model.
However, this limitation is not as severe as it may first appear. If discretionary accruals completely
reverse within the manager’s contracting horizon and such reversal can be detected, then there
is no role for earnings management in a contracting model. That being the case, we can simply
think of the modeled effect of earnings management in our setting as the non-reversing portion.
636 S . DUTTA AND F . GIGLER

manipulates, we assume that:

1 > λ H 1 > λ H0 > λ L1 > λ L0 > 0. (2)
Though the firm’s economic earnings are the manager’s private infor-
mation, the shareholders may choose to become informed about them by
inducing the manager to issue a report. We denote the manager’s report or
forecast by x̂, where x̂ ∈ {x L , x H }.8 It is natural to think of x̂ as an earnings
forecast. First, the manager’s report x̂ must be made to the shareholders
before the realization of y . Second, the manager’s best guess of the realiza-
tion of y is simply x because accounting earnings is a noisy representation
of economic earnings. Let s (x̂, y ) denote the manager’s compensation in
the state when he issues forecast x̂ and realized accounting earnings are y .
Shareholders are assumed to be identical and risk-neutral, and therefore
the manager’s compensation contract is chosen to maximize the following
collective objective function:
E [x − s (x̂, y )]. (3)
The risk-averse manager’s preferences are represented by an additively-
separable utility function U (s ) − Va (a) − Vm (m), where U (.) is strictly in-
creasing and concave. Without loss of generality, we normalize the disutility
of low productive effort, Va (al ), to zero, and write va for Va (ah ). Similarly, we
set Vm (0) equal to zero and use vm to denote Vm (1). The manager dislikes
providing productive effort (i.e., va > 0). We also allow for the possibility
that the manager dislikes manipulative activities, and hence assume that
vm ≥ 0.
In the first-best case, it is optimal to have the agent exert high productive
effort and to not engage in costly performance manipulation. To avoid
a trivial setting, we will restrict our attention to parameters such that the
shareholders also prefer to induce high productive effort in the second-
best case, even if it can be achieved only in combination with managerial
earnings manipulation. Thus, the shareholders’ objective is to minimize the
expected compensation cost of inducing the high level of productive effort.

3. Earnings Management and Earnings Forecasts

This section examines the conditions under which it is feasible to pre-
vent the manager from engaging in unproductive earnings management.
In particular, we are interested in examining how earnings forecasts affect
the degree of earnings management. To address this, we first characterize
the feasibility region (i.e., the parameter space under which it is feasible to
deter earnings management) without earnings forecasts, and then compare
it to the feasibility region in the presence of earnings forecasts.

8 We put a hat on x to emphasize the fact that the manager’s forecast does not have to

coincide with the firm’s economic earnings.

 THE EFFECT OF EARNINGS FORECASTS 637

When the manager is not asked to issue a forecast, his compensation

can depend on only accounting income. Let s (y ) denote the agent’s com-
pensation for y ∈ {y L , y H }. We use (m(x L ), m(x H )) to denote the earnings
manipulation strategy. The optimal compensation contract to induce high
productive effort and no manipulative action (i.e., strategy (0, 0)) solves the
following optimization problem:
Program P1
min E y [s (y ) | ah , m(x L ) = 0, m(x H ) = 0]
s (y )

subject to:
E y [U (s (y )) | ah , m(x L ) = 0, m(x H ) = 0] − va ≥ U (IR)

E y [U (s (y )) | ah , m(x L ) = 0, m(x H ) = 0] − va
≥ E y [U (s (y )) | al , m(x L ) = 0, m(x H ) = 0] (ICa)

E y [U (s (y )) | x L , m(x L ) = 0] ≥ E y [U (s (y )) | x L , m(x L ) = 1] − vm (ICm L )

E y [U (s (y )) | x H , m(x H ) = 0] ≥ E y [U (s (y )) | x H , m(x H ) = 1] − vm (ICm H )

The shareholders seek to minimize the expected cost of inducing the high
level of productive effort subject to certain constraints. (IR) is the manager’s
participation constraint. Constraint (ICa) ensures that the manager finds it
in his best interests to provide the high productive effort. Constraints (ICm L )
and (ICm H ) ensure that the manager does not engage in earnings manipu-
lation conditional on the low and high realization of the economic earnings,
respectively.9 Program 1 immediately yields the following result:
PROPOSITION 1. (i) Suppose λ L1 − λ L0 ≥ λ H1 − λ H0 . Then (0, 0) can be
induced without communication if and only if
vm va
≥ . (4)
(λ L1 − λ L0 ) ( ph − pl ) · (λ H0 − λ L0 )
(ii) When λ L1 − λ L0 < λ H1 − λ H0 , (0, 0) can be induced without communication
if and only if
vm va
≥ . (5)
(λ H1 − λ H0 ) ( ph − pl ) · (λ H0 − λ L0 )
The intuition underlying proposition 1 is quite straightforward. When the
manager can increase the probability of high accounting earnings at a lower
personal cost through manipulation than through productive effort, it be-
comes impossible to prevent earnings management. Inequalities (4) and (5)

9 We note that the expectations in constraints (ICm) are conditioned on the realized eco-

nomic earnings, and not on the manager’s choice of the productive action. This is a conse-
quence of our assumption that accounting earnings are simply a noisy version of economic
earnings.
638 S . DUTTA AND F . GIGLER

compare the manager’s marginal cost of increasing the probability of high

accounting earnings through manipulation to the cost of doing it through
productive effort. Since λ L1 − λ L0 ≥ λ H1 − λ H0 in case (i), the manager is
more effective at manipulating earnings in the low state (i.e., when x = x L )
than at manipulating in the high state (i.e., when x = x H ). Consequently, a
contract that discourages the manager from manipulating in the low state
will also prevent him from manipulating in the high state. The comparison
in inequality (4) is therefore between the cost of increasing the likelihood
of high accounting earnings by manipulating earnings in the low state and
the cost of increasing the likelihood of high accounting earnings through
productive effort. A similar intuition holds for the feasibility condition in
case (ii).
Now we characterize the region in which it is feasible to deter earnings
management when the manager is asked to communicate his private infor-
mation through an earnings forecast. With communication, compensation
contracts can rely on both accounting income y and the manager’s report
about the underlying economic income x̂. We refer to x̂ as the manager’s
earnings forecast. Let s (x̂, y ) denote the manager’s compensation as a func-
tion of the earnings forecast x̂ and realized accounting earnings y . Without
loss of generality, the Revelation Principle allows us to restrict our attention
to compensation schemes that induce the manager to report his informa-
tion truthfully. The optimal contract to induce (0, 0) therefore solves the
following program:
Program P2
min E x,y [s (x, y ) | ah , m(x L ) = 0, m(x H ) = 0]
s (x,y )

subject to:
E x,y [U (s (x, y )) | ah , m(x L ) = 0, m(x H ) = 0]−va ≥ U (IR)

E x,y [U (s (x, y )) | ah , m(x L ) = 0, m(x H ) = 0] − va

≥ E x,y [U (s (x, y )) | al , m(x L ) = 0, m(x H ) = 0] (ICa)
For every x̂ ∈ {x L , x H } and m(x L ) ∈ {0, 1}:
E y [U (s (x L , y )) | x L ,m(x L ) = 0]
≥ E y [U (s (x̂, y )) | x L ,m(x L )] − vm · m(x L ) (TTm L )
For every x̂ ∈ {x L , x H } and m(x H ) ∈ {0, 1}:
E y [U (s (x H , y )) | x H ,m(x H ) = 0]
≥E y [U (s (x̂, y )) | x H ,m(x H )] − vm · m(x H ) (TTm H )
Notice that constraints (ICm) of Program 1 have been replaced with cons-
traints (TTm) in Program 2. Constraints (TTm L ) and (TTm H ) ensure that
the manager refrains from earnings management and truthfully reports his
 THE EFFECT OF EARNINGS FORECASTS 639

private observation of economic income. An analysis of the incentive cons-

traints in Program 2 gives us the following feasibility result:
PROPOSITION 2. (i) Suppose λ L1 − λ L0 ≥ λ H1 − λ H0 . Then (0, 0) can be in-
duced with communication if and only if
vm va
≥ . (6)
(λ H1 − λ H0 ) ( ph − pl ) · (λ H1 − λ L1 )
(ii) When λ L1 − λ L0 < λ H1 − λ H0 , (0, 0) can be induced with communication
if and only if
vm va
≥ . (7)
(λ H1 − λ H0 ) ( ph − pl ) · (λ H0 − λ L0 )
Optimal communication contracts shield a manager who reports low eco-
nomic earnings from the risk associated with the accounting earnings. That
is, the optimal communication contract sets U L̂ H equal to U L̂L (where, for
brevity, we use U iˆ j to denote U (s (x̂ i , y j )). On the other hand, the optimal
contract penalizes the manager for reporting high economic income when
such a report is followed by low accounting income (i.e., U Ĥ H > U Ĥ L ). This
penalty must be sufficiently large to ensure that the low type manager (i.e.,
the manager who observes x = x L ) does not mimic the high type (i.e., the
manager who observes x = x H ) by issuing a high forecast and subsequently
manipulating earnings. On the other hand, this penalty cannot be too large,
otherwise the high type manager will have incentives to engage in earnings
manipulation.
In case (i), these two conflicting constraints require that:

vm U − U L̂ − vm
≥ U Ĥ H − U Ĥ L ≥ Ĥ , (8)
λ H1 − λ H0 λ H0 − λ L1

where U Ĥ ≡ λ H0 ·U Ĥ H + (1 − λ H0 ) ·U Ĥ L denotes the manager’s expected util-

ity contingent on a (truthful) report of x H , and U L̂ denotes the manager’s uti-
lity payoffs following a (truthful) forecast of x L . The right-hand side of in-
equality (8) can be interpreted as the low type manager’s net expected gains
from (falsely) issuing a high forecast and manipulating. The left-hand side
of (8) represents the high type manager’s expected cost of manipulation.
The feasibility condition in (6) follows from (8) because, in order to ensure
that the manager finds it desirable to undertake high productive effort, U Ĥ
must exceed U L̂ by at least an amount va · ( ph − pl )−1 . A similar intuition
holds in case (ii). In this case, however, the high type manager is more ef-
fective at earnings manipulation, and therefore the binding constraint for
the low type manager is concerned only with truth-telling (rather than with
both truth-telling and manipulation).
A comparison with proposition 1 reveals that the set of parameters under
which earnings manipulation can be completely eliminated expands when
the manager is asked to issue an earnings forecast. In particular, note that
there is a strict expansion of the region in which earnings manipulation can
640 S . DUTTA AND F . GIGLER

be eliminated with an earnings forecast in the case when λ L1 − λ L0 ≥ λ H1 −

λ H0 .10 This result is the basis of our conclusion that earnings management
is less likely to be prevalent when firms have issued earnings forecasts. In
what follows, define
va λ H1 − λ H0
vL ≡ ·
ph − pl λ H1 − λ L1
and
va λ L1 − λ L0
vH ≡ · .
ph − pl λ H0 − λ L0
COROLLARY. Suppose λ L1 − λ L0 ≥ λ H1 − λ H0 and vm ∈ [v L , v H ]. Then earn-
ings manipulation can be eliminated if and only if the manager is asked to provide
earnings forecasts.
Without communication, the only available performance measure (i.e.,
accounting earnings) must be used to achieve two incongruent goals: induce
productive effort, and deter earnings management. On the other hand,
when the manager is asked to issue an earnings forecast, the sharehold-
ers have two performance measures at their disposal: accounting earnings
and earnings forecasts. When the earnings forecast is used as a manage-
rial performance measure, however, it creates a control problem of its own.
Specifically, the accounting earnings must now also be used to prevent the
manager from misreporting his private information. Nonetheless, the com-
munication of the manager’s private information generally leads to an ex-
pansion of the region in which earnings management can be eliminated,
because a communication contract can use the earnings forecast to control
the productive effort and the accounting earnings to ensure honest forecasts
and deter earnings manipulation.11

4. Optimal Earnings Management

While the analysis in the previous section identifies conditions under
which it is feasible to eliminate earnings management, it does not address
the question of whether it would always be optimal to eliminate earnings
management. This section characterizes the shareholders’ optimal choice
of the earnings management strategy.
Recall that there are four possible earnings management strategies: (0, 0),
(0, 1), (1, 0), and (1, 1). It turns out that it is never optimal to induce the ma-
nager to manipulate earnings in the low state, i.e., strategies (1, 0) and (1, 1)
are dominated by strategies (0, 0) and (0, 1), respectively. To understand
why, we note that the earnings management can be potentially useful only if

10 When λ
L1 − λ L0 < λ H1 − λ H0 the regions over which earnings manipulation can be com-
pletely eliminated are identical with and without communication.
11 Melumad and Reichelstein [1989] show how communication can lead to an expansion

of the feasible action set in a pre-contract private information setting.

 THE EFFECT OF EARNINGS FORECASTS 641

the managed accounting earnings somehow make it easier to elicit truthful

forecasts of the economic earnings. When the low type manager is induced
to manipulate earnings, however, it becomes easier, rather than harder, for
him to mimic the high type. Consequently, the shareholders’ real choice is
between (0, 0) and (0, 1).
PROPOSITION 3. With communication, strategy (0, 1) is optimal when vm is be-
low a threshold level, and strategy (0, 0) is optimal when vm is above this threshold level.
We know from proposition 2 that when the manager’s personal cost of
manipulative action, vm , is relatively low, it is impossible to deter earnings
management entirely. In such a case, proposition 3 shows that the sharehold-
ers will optimally induce the manager to manipulate earnings in the high
state but not in the low state. Since it is never optimal to implement uncondi-
tional earnings management (i.e., strategy (1, 1)), or earnings management
conditional on a low forecast (i.e., strategy (1, 0)), proposition 3 shows that
earnings management will be observed only following a high forecast. This
prediction is broadly consistent with Kasznik’s [1999] empirical finding.
Interestingly, it turns out that such an asymmetric earnings management
strategy, i.e., strategy (0, 1), can always be induced. Recall that in an optimal
communication contract, the low type manager is completely insulated from
the “accounting risk” (i.e., the incremental risk associated with the account-
ing earnings). As a consequence, a manager who observes low economic
earnings (and reports truthfully) has no incentive to manipulate earnings,
because U L̂ H = U L̂L . The low type manager can thus be prevented from
engaging in earnings manipulation “for free,” in the sense that it imposes
no additional cost beyond the cost of inducing an honest forecast. Conse-
quently, it is always feasible to induce strategy (0, 1) with communication.
Clearly, it would be ideal to shield the manager entirely from the ac-
counting risk, and rely solely on the (less noisy) economic earnings to pro-
vide productive effort incentives. Such a contract, however, will induce the
low type manager to misreport his private information and mimic the high
type. To deter this, as noted earlier, the optimal communication contract
“penalizes” the manager for issuing a high forecast when such a forecast
is followed by low accounting income (i.e.,U Ĥ L < U Ĥ H ). Imposing such a
penalty, however, is costly because it exposes the risk-averse manager to
the accounting risk. A potential benefit of the conditional earnings man-
agement strategy (0, 1) is that it becomes more difficult for the low type
manager to mimic the high type. Put differently, the low type manager can
be deterred from misrepresenting his type by a smaller exposure to the
accounting risk (i.e., by a smaller spread between U Ĥ H and U Ĥ L ).12 This

12 In a pre-contract private information setting, Maggi and Rodriguez-Clare [1995] show

that the optimal incentive scheme may induce costly distortion of information. In their model,
such distortion is beneficial because it reduces the informational rents of the low cost types by
making it more difficult for them to mimic high cost types. In contrast, earnings management
is beneficial in our setting because a less risky contract can be used to separate types.
642 S . DUTTA AND F . GIGLER

suggests that the conditional earnings management strategy (0, 1) would be

preferred to the strategy of inducing no earnings management, (0, 0).
However, proposition 3 shows that when the manager’s personal cost of
manipulative action is sufficiently large, the shareholders prefer to eliminate
earnings management entirely. To understand why, we note that the contract
to induce (0, 0) exists only when the cost of manipulation is sufficiently large.
In this region, the high type manager will have to be “induced” to manipulate
earnings through a large enough spread between U Ĥ H and U Ĥ L . That is,
the optimal risk in the manager’s compensation contract is determined
by the high type manager’s manipulation constraint rather than by the low
type manager’s truth-telling constraint. This, in combination with the fact
that the manager also has to be compensated for his direct personal cost of
manipulative action, leads to the result that strategy (0, 0) dominates (0, 1)
when vm is large.
In figure 1, we plot the expected compensation cost to induce high pro-
ductive effort as a function of vm in the case when the manager is more
effective at manipulating earnings in the low state. When vm > v H , the high
productive effort can be implemented without earnings manipulation. Since

FIG. 1.—Expected compensation cost to induce high effort.

 THE EFFECT OF EARNINGS FORECASTS 643

it is relatively costly for the manager to engage in earnings management, the

optimal contract to induce strategy (0, 0) is determined as though it were fea-
sible to prohibit earnings management directly. Consequently, as illustrated
in figure 1, the expected compensation cost of inducing strategy (0, 0) is flat
in this region. Since earnings management can be eliminated even without
communication in this region, the only benefit of a communication-based
contract is the improvement in risk sharing.
When vm ∈ [v L , v H ], strategy (0, 0) can be induced only if the manager
is asked to provide an earnings forecast. The expected compensation cost
of inducing (0, 0) is decreasing in vm . Intuitively, as vm increases, the low
type manager finds it increasingly less attractive to misreport his private
information and engage in earnings manipulation. Consequently, the opti-
mal contract requires increasingly smaller spread between U Ĥ H and U Ĥ L in
order to deter the low type manager from following such a strategy.
In figure 1, we also plot the expected compensation cost of implement-
ing strategy (0, 1). When vm is above v ∗ , the expected compensation cost is
increasing in vm . In this region, the optimal spread between U Ĥ H and U Ĥ L is
determined by the high type manager’s manipulation constraint, rather than
by the low type manager’s truth-telling constraint. As a consequence, the op-
timal contract becomes increasingly more risky as vm increases. In addition
to this adverse effect, there is the direct cost of compensating the manager
for his disutility of manipulation (i.e., ph · vm ). Since these two effects work in
the same direction, the expected compensation cost is increasing in vm . And
since v ∗ is less than v L , the expected cost of implementing strategy (0, 1)
is increasing in vm when ever the expected cost of implementing (0, 0) is
decreasing in vm . This is why there is a single threshold value of vm , below
which (0, 1) is optimal and above which (0, 0) is optimal. Notice that this
threshold value of vm is located at or above v L .
When vm < v ∗ , the optimal spread between U Ĥ H and U Ĥ L is determined
by the low type manager’s incentives to report truthfully. As vm increases, the
low type manager finds it increasingly less attractive to manipulate. Conse-
quently, a smaller spread between U Ĥ H and U Ĥ L suffices to deter him from
misreporting and manipulating earnings. Whether the expected compen-
sation cost is decreasing or increasing, therefore, depends on the relative
magnitudes of the direct and indirect effects. This means that the value of vm
that minimizes the expected cost of implementing strategy (0, 1) is greater
than or equal to zero and less than v ∗ . For sufficiently small values of ph , the
indirect effect dominates and the expected compensation cost decreases
for a nonempty region adjacent to the origin, making the cost minimizing
value of vm strictly greater than zero.
Similarly, figure 2 illustrates the owner’s expected compensation cost to
induce strategies (0, 0) and (0, 1) for the case when the manager is more
effective at manipulating earnings in the high state. We note that, unlike
in case (i), the optimal contract to induce (0, 1) is characterized by three
distinct regions. When vm is sufficiently small, the optimal spread between
U Ĥ H and U Ĥ L is determined by the constraint that the low type manager
644 S . DUTTA AND F . GIGLER

FIG. 2.—Expected compensation cost to induce high effort.

finds it in his interest to report truthfully and abstain from earnings manip-
ulation. In this region, the slope of the expected compensation cost curve
is determined by the relative magnitudes of the direct and indirect effects.
When vm is sufficiently large, the optimal spread between U Ĥ H and U Ĥ L is
determined by the constraint that the high type manager finds it beneficial
to manipulate, and hence the expected compensation cost is unambigu-
ously increasing in vm . For intermediate values of vm , the optimal contract is
determined as though it were feasible to directly prohibit the manager from
earnings manipulation in the low state. In this region the optimal level of
risk is constant in vm , and therefore the expected compensation cost is in-
creasing in vm solely because of the direct effect. Again, the threshold value
of vm that determines the optimal strategy is unique since the expected cost
of implementing strategy (0, 0) is constant in vm and the expected cost of im-
plementing (0, 1) is increasing in vm wherever the strategy (0, 0) is feasible.

5. Effect of Accounting and Auditing Standards

Our analysis has thus far characterized the optimal degree and type of
earnings management under the assumption that the shareholders have
no control over the effectiveness with which the manager can manipulate
earnings. In many instances, the shareholders may be able to influence the
 THE EFFECT OF EARNINGS FORECASTS 645

relative effectiveness of earnings management, or alternatively the man-

ager’s personal cost of earnings manipulation, through their choice of ac-
counting and auditing standards. In this section, we examine whether the
shareholders would necessarily prefer accounting and auditing systems that
make it prohibitively costly for the manager to engage in earnings manipu-
lation.
In this regard, we note that figure 2 was intentionally drawn to suggest
the possibility that the minimum expected compensation cost of inducing
the high productive effort might occur in the region in which strategy (0, 1)
would be induced. This means that even if the shareholders could cost-
lessly impose a prohibition on earnings management or, alternatively, make
earnings management prohibitively costly to the manager, they might not
choose to do so. For instance, in figure 2 the expected compensation cost
is minimized at vm = v ∗ . Consequently, if the shareholders could choose the
manager’s cost of manipulative action, they would choose it to be v ∗ . In
this case, accounting and auditing standards that overly restrict the mana-
ger’s ability to engage in earnings management would be detrimental to the
shareholders.
When the manager’s personal cost of manipulation exceeds a certain
threshold (defined by v H in case (i) and condition (7) in case (ii)), the
optimal contract to induce high productive effort is identical to the one
that would be optimal in a setting in which earnings management could
be directly prohibited. For this reason, we say that earnings management
is prohibitively costly to the manager when vm exceeds this threshold level.
The result below identifies a necessary and a sufficient condition such that
the shareholders will prefer accounting and auditing standards sufficiently
lax so as not to make earnings manipulation prohibitively costly.
PROPOSITION 4. (i) If λ H1 − λ H0 is sufficiently large, it is sub-optimal to
make earnings management prohibitively costly to the manager. (ii) If λ H1 − λ H0 is
sufficiently small, it is optimal to make earnings management prohibitively costly to
the manager.
To understand the intuition behind this result, consider an extreme set-
ting in which the manager is so effective at manipulating in the high state
that he can generate high accounting income with probability one (i.e.,
λ H1 = 1). In such a setting, the optimal contract can be effectively designed
as though the economic earnings were directly available for contracting pur-
poses, rather than having to be elicited from the manager. To see this, recall
that the only reason that the manager is exposed to the accounting risk
is to prevent him from misreporting his type when the state is low. When
the manager is extremely effective at manipulating earnings in the high
state (i.e., λ H1 = 1), however, he can be prevented from misreporting his
information in the low state through a risk-less forcing contract. This is the
reason that when λ H1 − λ H0 is sufficiently large, the shareholders will prefer
to choose a small vm and induce strategy (0, 1), rather than choose a large
vm and induce strategy (0, 0).
646 S . DUTTA AND F . GIGLER

On the other hand, when the manager is relatively ineffective at manip-

ulating earnings in the high state (i.e., λ H1 − λ H0 is relatively small), the
optimal spread between U Ĥ H and U Ĥ L is determined by the constraint that
the high type manager finds it beneficial to engage in earnings manipula-
tion. Furthermore, when λ H1 − λ H0 is relatively small, the spread between
U Ĥ H and U Ĥ L is a sufficient measure of the amount of risk in the contract.
As a consequence, it follows that even from purely an incentive perspective
(i.e., without factoring in the direct cost of earnings manipulation), stra-
tegy (0, 1) is inferior to (0, 0) because it results in a riskier contract. This
is the reason that the shareholders prefer to make earnings management
prohibitively costly and induce strategy (0, 0), rather than choose a small
vm and induce strategy (0, 1).
To conclude this section, we compare our main findings to the results
from the earlier earnings management literature that relies on violation
of some assumptions underlying the Revelation Principle. Demski [1998]
demonstrates that the principal may find it optimal to induce the agent to
engage in performance manipulation under the assumption that the agent
cannot fully communicate his private information. In effect, the manipula-
tion serves as a substitute for communication. Demski and Frimor [1999],
Christensen, Demski, and Frimor [2001], and Arya, Glover, and Sunder
[1998] assume that the principal is unable to make long-term commitments.
Consequently, the principal engages in ex post opportunistic actions that are
detrimental from an ex ante perspective. In such settings, earnings manage-
ment is beneficial as it restricts the amount of information that the principal
receives at the renegotiation stage. The principal thus finds it desirable to
induce earnings management, i.e., garbling of information, in order to dis-
cipline his ex post opportunistic behavior. In contrast to the above papers, our
paper takes a more traditional contracting approach in which the principal
can make commitments and communication is unrestricted. Nonetheless,
our analysis establishes that earnings management can be beneficial as it
reduces the cost of eliciting truthful forecasts from the manager.

6. Conclusions
We have modeled earnings management as a deliberate manipulative
action choice that the manager makes after privately observing the firm’s
true or economic earnings. When the manager is not asked to communicate
the underlying economic earnings through earnings forecasts, productive
effort incentives require that compensation be increasing in accounting
earnings. But it is a contingent contract of this very type that tempts the
manager to engage in earnings management.
Our analysis has identified circumstances under which the manager can
be induced to provide high productive effort and abstain from earnings ma-
nagement. We have shown that the parameter space over which the manager
can be prevented from earnings management (and yet induced to provide
high productive effort) expands if the manager is asked to communicate
 THE EFFECT OF EARNINGS FORECASTS 647

the underlying economic earnings through earnings forecasts. Thus, we

find that earnings management is less likely in the presence of an earnings
forecast, seemingly at odds with conventional notions.
Our analysis also shows that in an optimal contracting setting earnings
management is more likely to occur following high earnings forecasts than
low earnings forecasts. Finally our analysis characterizes circumstances un-
der which the shareholders would be harmed and helped by accounting
and auditing standards that make it prohibitively costly for the manager to
engage in earnings management. Interestingly, our analysis shows that for
a large class of parameters the shareholders would not find it optimal to
design an overly restrictive accounting and auditing system.

APPENDIX

PROOF OF PROPOSITION 1. For brevity, we write s H for s(y H ) and s L for

s(y L ). Then the three incentive compatibility constraints in program P1
simplify to:
va
U (s H ) − U (s L ) ≥ . (ICa)
( ph − pl ) · (λ H0 − λ L0 )
vm
U (s H ) − U (s L ) ≤ . (ICm L )
λ L1 − λ L0
vm
U (s H ) − U (s L ) ≤ . (ICm H )
λ H1 − λ H0
When λ H1 − λ H0 ≤ λ L1 − λ L0 , these three constraints can be satisfied if and
only if condition (4) holds. If λ H1 − λ H0 > λ L1 − λ L0 , these three constraints
can be satisfied if, and only if, condition (5) holds. This proves proposition 1.
PROOF OF PROPOSITION 2. For brevity, we write U iˆ j to denote
U (s (x̂ i , y j )). For example U Ĥ L denotes U (s (x̂ H , y L )). For notational conve-
nience, we also define:

U Ĥ ≡ λ H0 · U Ĥ H + (1 − λ H0 ) · U Ĥ L , (A1)
U L̂ ≡ λ L0 · U L̂ H + (1 − λ L0 ) · U L̂L . (A2)

Then the six TT constraints of program P2 are as follows:

U Ĥ ≥ [λ H1 · U Ĥ H + (1 − λ H1 ) · U Ĥ L ] − vm (i)
U Ĥ ≥ [λ H1 · U L̂ H + (1 − λ H1 ) · U L̂L ] − vm (ii)
U Ĥ ≥ [λ H0 · U L̂ H + (1 − λ H0 ) · U L̂L ] (iii)
U L̂ ≥ [λ L1 · U L̂ H + (1 − λ L1 ) · U L̂L ] − vm (iv)
U L̂ ≥ [λ L1 · U Ĥ H + (1 − λ L1 ) · U Ĥ L ] − vm (v)
U L̂ ≥ [λ L0 · U Ĥ H + (1 − λ L0 ) · U Ĥ L ] (vi)
648 S . DUTTA AND F . GIGLER

PROOF OF THE NECESSITY PART. Constraint (ICa) can be written as:

va
U Ĥ − U L̂ ≥ . (A3)
p h − pl
(i) yields the following inequality:
vm
U Ĥ H − U Ĥ L ≤ , (A4)
λ H1 − λ H0
while (v) is equivalent to U Ĥ − U L̂ ≤ vm + (λ H0 − λ L1 )(U Ĥ H − U Ĥ L ). Sub-
stituting (A4) gives
λ H1 − λ L1
U Ĥ − U L̂ ≤ vm . (A5)
λ H1 − λ H0
Constraint (vi) is equivalent to U Ĥ − U L̂ ≤ (λ H0 − λ L0 )(U Ĥ H − U Ĥ L ). Substi-
tuting (A4) gives:
λ H0 − λ L0
U Ĥ − U L̂ ≤ vm . (A6)
λ H1 − λ H0
In case (i), (A5) implies (A6), and therefore a necessary condition for the
feasibility of strategy (0, 0) is defined by (A3) and (A5). In case (ii), (A6)
implies (A5), and hence a necessary condition for the feasibility of strat-
egy (0,0) is defined by (A3) and (A6). This proves the necessity part of
proposition 3.
PROOF OF THE SUFFICIENCY PART. In order to prove the sufficiency, we
derive the optimal contract to induce strategy (0, 0). This consists of the
following ten claims:
CLAIM 1. U L̂L ≥ U Ĥ L .
PROOF. To the contrary, suppose U L̂L = U Ĥ L − t, where t > 0. Substitut-
ing U L̂L = U Ĥ L − t in (iii) and (vi) respectively yield U Ĥ H − U L̂ H ≥ −t · 1 −λ H0
λ H0

and U Ĥ H − U L̂ H ≤ −t · λL0 . These two inequalities require that λL0 ≤

1−λ L0 1−λ L0

1−λ H0
λ H0
, which cannot hold since λ H0 > λ L0 .
CLAIM 2. (i) and (iii) imply (ii).
PROOF. Let  denote the difference between the right-hand sides of
inequalities (i) and (ii). Then

 = λ H 1 (U Ĥ H − U L̂ H ) − (1 − λ H 1 )(U L̂L − U Ĥ L )
 
1 − λH 1
= λ H 1 (U Ĥ H − U L̂ H ) − (U L̂L − U Ĥ L ) .
λH 1
Constraint (iii) implies
1 − λ H0 1 − λ H1
U Ĥ H − U L̂ H ≥ (U L̂L − U Ĥ L ) ≥ (U L̂L − U Ĥ L ).
λ H0 λ H1
 THE EFFECT OF EARNINGS FORECASTS 649

The last inequality follows from claim 1 and the fact that λ H1 ≥ λ H0 . Substi-
tuting this in the expression for  proves the result.
CLAIM 3. U L̂L ≥ U L̂ H .
PROOF. To the contrary, suppose U L̂L < U L̂ H . Consider a variation of the
original contract in which U L̂ H is reduced by t(t > 0) and U L̂L increased by
λ L0
1−λ L0
· t. It is easy to verify that this variation adds slack to (iii) and (v) but
has no effect on (IR), (ICa), (i), (v), and (vi). This variation changes the
expected compensation cost by the amount:

(1 − ph ) λ L0 [G (U L̂ H − t) − G (U L̂ H )] + (1 − λ L0 )
   
λ L0
× G U L̂L + t − G (U L̂L ) ,
1 − λ L0
where G (·) denotes the inverse of the manager’s utility function. As t → 0,
this amount simplifies to -(1 − ph )(1 − λ L0 )(G  (U L̂ H ) − G  (U L̂L )), which is
strictly negative since G  > 0 and U L̂L < U L̂ H . This contradicts the optimality
of the original contract.
CLAIM 4. Constraint (iii) will never bind.
PROOF. Note that
U L̂ ≡ λ L0 U L̂ H + (1 − λ L0 )U L̂L = U L̂L − λ L0 (U L̂L − U L̂ H )
≥ U L̂L − λ H0 (U L̂L − U L̂ H ) = λ H0 · U L̂ H + (1 − λ H0 ) · U L̂L . (A7)
The inequality in (A7) is a consequence of the facts that λ H0 > λ L0 and
U L̂L ≥ U L̂ H (see claim 3). Since ICa requires that U Ĥ > U L̂ , (A7) yields
U Ĥ > λ H0 · U L̂ H + (1 − λ H0 ) · U L̂L . This proves the claim.
As a result of the last four claims, the original set of constraints in program
P2 can be replaced with (IR), (ICa), (i), (v), (vi), and the constraint that
U L̂L ≥ U L̂ H .
CLAIM 5. U L̂L = U L̂ H .
PROOF. To the contrary, suppose U L̂L > U L̂ H . Consider a variation of the
original contract in which U L̂L is reduced by a small positive amount t and
U L̂ H is increased by 1−λ
λ L0
L0
· t. This variation has no effect on (IR), (ICa), (i),
(v), and (vi). This variation changes the expected compensation cost by the
amount:
    
1 − λ L0
(1 − ph ) λ L0 G U L̂ H + t − G (U L̂ H )
λ L0

+ (1 − λ L0 )[G (U L̂L − t) − G (U L̂L )] .

As t → 0, the above expression simplifies to (1 − ph )λ L0 (G  (U L̂ H ) −

G  (U L̂L )), which is strictly negative since U L̂L > U L̂ H . This contradicts the
optimality of the original contract.
650 S . DUTTA AND F . GIGLER

CLAIM 6. U Ĥ H > U L̂ H > U Ĥ L .

PROOF. Follows by substituting U L̂L = U L̂ H (claim 5) and U L̂L ≥ U Ĥ L
(claim 1) into (A7).
CLAIM 7. Either (v) or (vi) must bind.
PROOF. To the contrary, suppose both (v) and (vi) are slack. Therefore,
one can find a positive constant t1 such that if U Ĥ H is decreased by t1 and
λ H0
U Ĥ L is increased by 1−λ H0
· t1 , then constraint (v) binds. Similarly, one can
find another positive constant t2 such that if U Ĥ H is decreased by t2 and U Ĥ L
λ H0
is increased by 1−λ H0
· t2 , then constraint (vi) binds. Consider a variation of
the original contract in which U Ĥ H is reduced by t and U Ĥ L is increased by
λ H0
1−λ H0
· t, where t ≤ min {t1 , t2 }. This variation satisfies both (v) and (vi), has
no effect on (IR), (ICa), or the constraint U L̂L ≥ U L̂ H , and adds slack to (i).
The variation changes the expected compensation cost by the amount:

ph λ H0 [G (U Ĥ H − t) − G (U Ĥ H )] + (1 − λ H0 )
   
λ H0
× G U Ĥ L + t − G (U Ĥ L ) .
1 − λ H0
As t → 0, the above expression simplifies to − ph (1 − λ H0 )(G  (U Ĥ H ) −
G  (U Ĥ L )), which is strictly negative since U Ĥ H > U Ĥ L (see claim 6). This
contradicts the optimality of the original contract.
CLAIM 8. (IR) and (ICa) bind.
PROOF. (IR) must bind because otherwise it would be possible to uni-
formly reduce all of the (utility) payments without affecting any other con-
straints. Suppose now (ICa) is slack. Consider a variation of the original
contract in which U L̂L (and U L̂ H ) is increased by t and U Ĥ H is decreased by
1− ph
ph ·λ H0
· t, where t > 0. This variation adds slack to (i), (v) and (vi) but has
no effect on (IR). The variation changes the expected compensation cost
by the amount:
   
1 − ph
ph λ H0 G U Ĥ H − t − G (U Ĥ H ) + (1 − ph )[G (U L̂ + t) − G (U L̂ )].
ph · λ H0
As t → 0, the above expression simplifies to − ph λ H0 (G  (U Ĥ H ) − G  (U L̂ )),
which is strictly negative since U Ĥ H > U L̂ . This contradicts the optimality of
the original contract.
CLAIM 9. Suppose λ H1 − λ H0 ≤ λ L1 − λ L0 . If vm > v H , then (vi) binds. If
vm ∈ [v L , v H ], then (v) binds.
PROOF. Constraint (ICa) requires that U Ĥ − U L̂ = phv−a pl . This yields
vm
(i) ⇔ U Ĥ H − U Ĥ L ≤ ,
λ H1 − λ H0
va
(v) ⇔ ≤ vm + (λ H0 − λ L1 )(U Ĥ H − U Ĥ L ),
p h − pl
 THE EFFECT OF EARNINGS FORECASTS 651
va
(vi) ⇔ ≤ (λ H0 − λ L0 )(U Ĥ H − U Ĥ L ).
p h − pl
Suppose (vi) binds. Substituting for U Ĥ H − U Ĥ L from (vi) into (i) and (v)
yield, respectively:
va λ H0 − λ L0
≤ vm (A7)
p h − pl λ H1 − λ H0
va λ H0 − λ L0
≤ vm (A8)
p h − pl λ L1 − λ L0
(A7) is implied by (A8) given the assumption λ H1 − λ H0 ≤ λ L1 − λ L0 . (A8) is
equivalent to the condition vm > v H . When constraint (vi) binds, therefore,
constraints (v) and (i) are satisfied if and only if vm > v H .
Now suppose (v) binds. Substituting for U Ĥ H − U Ĥ L from (v) into (i) and
(vi) yield:
va λ H1 − λ L1
≤ vm (A9)
p h − pl λ H1 − λ H0
va λ H0 − λ L0
≥ vm (A10)
p h − pl λ L1 − λ L0
(A9) and (A10) are equivalent to the condition that vm ∈ [v L , v H ]. There-
fore, when constraint (v) binds, constraints (vi) and (i) are both satisfied if,
and only if, vm ∈ [v L , v H ]. Since we know that either (v) or (vi) must bind,
this proves the claim.
CLAIM 10. Suppose λ H1 −λ H0 > λ L1 −λ L0 . Whenever condition (7) holds,
constraint (vi) binds.
PROOF. We skip the proof since it follows similar steps as in claim 9.
For future reference, we state the following result which follows imme-
diately from the optimality condition U L̂L = U L̂ H and the three relevant
binding constraints for the three remaining unknowns:
LEMMA A1. (i) If λ H1 −λ H0 ≤ λ L1 −λ L0 , then the optimal contract to implement
(0, 0) is given by:
va · pl
U L̂ H = U L̂L ≡ U L̂ = U − , (A11)
p h − pl
va
U Ĥ = U L̂ + , (A12)
p h − pl
and
va
U Ĥ H − U Ĥ L = if vm > v H (A13)
( ph − pl ) · (λ H0 − λ L0 )
U Ĥ H − U Ĥ L
va vm
= − if vm ∈ [v L , v H ]. (A14)
( ph − pl ) · (λ H0 − λ L1 ) (λ H0 − λ L1 )
652 S . DUTTA AND F . GIGLER

(ii) If λ H1 − λ H0 > λ L1 − λ L0 , then the optimal contract to implement (0, 0) is

given by (A11)–(A13) whenever condition (7) of Proposition 2 holds.

PROOF OF PROPOSITION 2.
Step I
It is always feasible to induce (0, 1) with communication. The optimal con-
tract to induce (0, 1) is given by:

va · pl
U L̂ H = U L̂L = U L̂ ≡ U − + p h · vm (A15)
p h − pl
va
U Ĥ ≡ λ H1 · U Ĥ H + (1 − λ H1 ) · U Ĥ L = U L̂ + , (A16)
p h − pl
va vm
U Ĥ H − U Ĥ L = − if vm < v,
( ph − pl ) · (λ H1 − λ L1 ) (λ H1 − λ L1 )
va
= if vm ∈ [v, v̄], (A17)
( ph − pl ) · (λ H1 − λ L0 )
vm
= if vm ≥ v̄.
(λ H1 − λ H0 )

PROOF. We skip the proof since the steps involved are similar to those
used in deriving the optimal contract to induce (0, 0) in the proof of propo-
sition 3. We note that v = v̄ in case (i), and v < v̄ in case (ii).
Step II
Let C (m(x L ), m(x H )) denote the cost of inducing strategy (m(x L ), m(x H )).
Strategy (0, 0) can be induced whenever (1, 0) can be induced. Furthermore,
C (0, 0) < C (1, 0).
PROOF. Suppose contract 10 ≡ (U Ĥ H , U Ĥ L , U L̂ H , U L̂L ) optimally indu-
ces (1, 0). Consider a modification of this contract, which eliminates the
accounting risk in the low state. Let 00 denote this modified contract, and
therefore 00 = (U Ĥ H , U Ĥ L , U L̂ , U L̂ ), where U L̂ ≡ λ L1 ·U L̂ H + (1−λ L1 )·U L̂L .
We show that this modified contract can be used to induce (0, 0). First, note
that 00 satisfies the participation constraint since

E U ( 01 ) ≡ ph · [λ H1 · U Ĥ H + (1 − λ H1 ) · U Ĥ L ] + (1 − ph ) · U L̂ − va
> ph · [λ H1 · U Ĥ H + (1 − λ H1 ) · U Ĥ L ]
+ (1 − ph ) · U L̂ − va − vm · (1 − ph )
= U.

The modified contract also satisfies the manager’s effort incentive com-
patibility constraint since it is identical to the one satisfied by the original
contract in inducing (1, 0).
 THE EFFECT OF EARNINGS FORECASTS 653

Furthermore, note that the original contract, 10 , satisfies the following

truth-telling constraints:
λ H0 · U Ĥ H + (1 − λ H0 ) · U Ĥ L ≥ [λ H1 · U Ĥ H + (1 − λ H1 ) · U Ĥ L ] − vm (T1)
λ H0 · U Ĥ H + (1 − λ H0 ) · U Ĥ L ≥ [λ H1 · U L̂ H + (1 − λ H1 ) · U L̂L ] − vm (T2)
λ H0 · U Ĥ H + (1 − λ H0 ) · U Ĥ L ≥ [λ H0 · U L̂ H + (1 − λ H0 ) · U L̂L ] (T3)
U L̂ − vm ≥ [λ L0 · U L̂ H + (1 − λ L0 ) · U L̂L ] (T4)
U L̂ − vm ≥ [λ L1 · U Ĥ H + (1 − λ L1 ) · U Ĥ L ] − vm (T5)
U L̂ − vm ≥ [λ L0 · U Ĥ H + (1 − λ L0 ) · U Ĥ L ]. (T6)
Given inequalities (T4)–(T6), it is easy to see that contract 00 also satisfies
the corresponding low state truth-telling constraints (i.e., constraints (iii)–
(vi) in the proof of proposition 2). Furthermore, constraint (T4) implies
that U L̂ H > U L̂L . Substituting this in the right hand sides of (T2) and (T3),
we get:
λ H0 · U Ĥ H + (1 − λ H0 ) · U Ĥ L > U L̂ − vm (T2 )
λ H0 · U Ĥ H + (1 − λ H0 ) · U Ĥ L > U L̂ (T3 )
It now follows that contract 00 also satisfies the high state truth-telling
constraints given by inequalities (i)–(iii) in the proof of proposition 2. To
see this, note that (i) follows from (T1), (ii) follows from (T2 ), and (iii)
follows from (T3 ).
This proves that contract 00 will induce the strategy (0, 0) and satisfy the
manager’s participation constraint. Contract 00 dominates 10 because it
(i) is identical to contract 10 in the high state, and (ii) is less risky than
contract 10 in the low state. This proves that C (0, 0) < C (1, 0).
Step III
C (0, 1) < C (1, 1).
PROOF. Using arguments identical to the proof of Step III, it can be
shown that the optimal contract to induce (1, 1), whenever it exists, can be
modified (by removing the low state accounting risk) and used to induce
(0, 1).
Step IV
If vm is below [above] a threshold level, it is optimal to induce (0, 1) [(0, 0)].
PROOF. From Steps II and III, it follows that the optimal strategy is ei-
ther (0, 1) or (0, 0). Let C (m(x L ), m(x H ) | vm ) denote the expected cost
of inducing strategy (m(x L ), m(x H )) for a given vm . Using the closed form
solution for the optimal contract to induce (0, 0) (see lemma A1), it can be
directly verified that C (0, 0 | vm ) is (weakly) decreasing in vm . Similarly, us-
ing the optimal contract given in step I, it can be checked that C (0, 1 | vm ) is
strictly increasing in all of the upper-tailed region where the strategy (0, 0) is
654 S . DUTTA AND F . GIGLER

feasible. This implies that there exists a unique w > 0 such that C (0, 0 | vm ) <
C (0, 1 | vm ) if and only if vm > w.
PROOF OF PROPOSITION 4.
In order to prove part (i), we will show that if λ H1 − λ H0 is sufficiently
large, then there exists a region of vm (adjacent to the origin) such that
C (0, 1 | vm ) in this region is strictly less than the minimum value of C (0,
0 | vm ). Let C  (0, 0) denote the minimum value of C (0, 0 | vm ).13 To prove
the result, therefore, we need to show that when λ H1 → 1, C (0, 1 | vm =
0) < C  (0, 0).
From step I in the proof of proposition 3, we know that the optimal
contract to induce (0, 1) at vm = 0 and λ H1 = 1 is given by U L̂ = U −
λ L1
va · pl , U Ĥ H = U L̂ + va , and U Ĥ L = U L̂ − va · 1−λ L1
, where va ≡ phv−a pl . There-
fore,
C (0, 1 | vm = 0) = ph · G (U L̂ + va ) + (1 − ph ) · G (U L̂ ).
On the other hand,
C  (0, 0) = ph · [λ H0 · G (U Ĥ H ) + (1 − λ H0 ) · G (U Ĥ L )] + (1 − ph ) · G (U L̂ ),
where the optimal contract to induce (0, 0) is given by expressions (A11)–
(A13). Using these expressions, it can be verified that λ H0 ·U Ĥ H + (1−λ H0 )·
U Ĥ L = U L̂ + va . Since G (·) is strictly convex, a direct comparison reveals
that C (0, 1 | vm = 0) < C  (0, 0). By continuity, it then follows that when λ H1
is sufficiently large relative to λ H0 , there exists a region of vm adjacent to the
origin in which the cost of inducing (0, 1) is strictly less than the minimum
cost of inducing (0, 0). This proves part (i).
To prove part (ii), we show that when λ H1 → λ H0 , C (0, 1 | vm ) > C  (0, 0)
for all values of vm . To show this, let us evaluate C (0, 1 | vm ) for the value of
vm at which the optimal contract to induce (0, 1) entails the lowest spread
between U Ĥ H and U Ĥ L . From step I in the proof of proposition 3, it can be
verified that the optimal spread between U Ĥ H and U Ĥ L is minimized when
vm v −v
λ H1 −λ H0
= λ H1a −λmL1 . Substituting this in expressions for the optimal contract
given in step I yields
1 + λ H1 − λ H0 − λ L1
U Ĥ H = U L̂ + va · (A18)
2 · λ H1 − λ L1 − λ H0
λ H1 − λ H0 − λ L1
U Ĥ L = U L̂ + va · (A19)
2 · λ H1 − λ L1 − λ H0
Consider now a modification of the optimal contract given by (A15), (A16),
(A18), and (A19) such that all (utility) payments are uniformly reduced by
an amount of ph · vm . For brevity, let m denote this modified contract.
Clearly, the expected compensation cost of contract m is less than C (0,
1 | vm ) for any vm . To prove the result, therefore, it suffices to show that the

13 Recall that C (0, 0 | v ) achieves its minimum at v = v , and stays at its minimum value
m m H
for all vm ≥ v H .
 THE EFFECT OF EARNINGS FORECASTS 655

expected cost of contract m exceeds C  (0, 0). The last result follows since,
as λ H1 → λ H0 : (i) the cost of contract m is strictly increasing in λ L1 , and (ii)
the contract m converges to the optimal contract to induce (0, 0) when
λ L1 = λ L0 .

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