.lournal of Accounting Research Vol. 26 No. 2 Autumn 1988 Printed in U.S.A.

Earnings Management in an Overlapping Generations Model

RONALD A. DYE*

1. Introduction
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 management to implement, they must design a contract to encourage management 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 "external 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 management induced by current shareholders' attempts to alter prospective investors' perceptions of the firm's value.

* Northwestern University. I wish to thank Joel Demski, workshop participants at the University of California at Los Angeles, Northwestern University, the University of Pennsylvania, and two anonymous referees for helpful comments on previous drafts. Research support was provided by the Accounting Research Center at Northwestern University and the Institute of Professional Accounting at the University of Chicago. [Accepted for publication July 1988.] 195
(Aif>yrixlit (-'. InMiiute of Prol'cR.';ional Accounting 1988

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JOURNAL OF ACCOUNTING RESEARCH, AUTUMN 1988

To assert that shareholders might have a demand for earnings management might seem perverse, since unmanaged earnings are typically considered preferred to managed earnings, ceteris parihus. But the assumptions implicit in the ceteris paribus qualification are frequently nol tenable. For example, to give a manager no incentive to engage in earnings management may necessitate altering his compensation scheme by making it independent of accounting data. Such alterations may change the manager's preferred action choice. So it may be impossible to eliminate earnings management while holding the manager's action choice cori' stant. The purpose of this theory is to describe necessary and sufficient conditions for earnings management to occur, to identify how the internal and external demands for earnings management differentially alfect the firm's optimal earnings announcement policies, and to indicate the benefits and costs to shareholders of earnings manipulation. The two principal factors which generate earnings management in these models are the inability of managers to communicate all dimensions of their private information to shareholders and the inability of investors to reveal completely all facets of their managers' compensation schedules to prospective investors. These considerations play a prominent role because they affect the applicability of the Revelation Principle (Harris and Townsend [1981], Holmstrom [1978], and Myerson 11979]) to this model of earnings management. Although the Revelation Principle which, loosely speaking, states that a contract can be designed so as to give each of the parties to it an incentive to reveal his/her private information truthfully^was originally designed simply as a technical device to help characterize resource allocations in asymmetric information environments, it is in fact central to any explanation of earnings management: when the Revelation Principle applies to a model which depicts earnings management, there exists another equilibrium of the model in which earnings management does not occur. The theory also provides implications about the magnitude and direction of stock price reactions to earnings announcements and identifies when shareholders are better off if their managers issue two distinct earnings announcements (one private, for purposes of appraising management's performance and influencing management's compensation, and another public, for purposes of influencing prospective investors" opinions of the value of the firm). The study of the internal demand for earnings management requires appraising the stewardship value of earnings announcements. A singleperiod agency model, modified hy assuming that the firm's economic earnings are not publicly observable, is suitable for its study. Studyinj; the external demand for earnings management necessitates differentiating between a firm's current shareholders and its prospective investors. We accomplish this by employing an "overlapping generations" model

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(Samuelson [1958]), in which one generation of shareholders transfers the ownership of the firm to the next generation through a stock market. The demand for earnings management derives from one shareholder generation's attempt to impress the next generation with the firm's past performance. The analysis is affected by the length of time the firm's manager stays in office. If a manager stays in office for only one generation, his opportunities for earnings management are limited to the one time while he is in office that the firm goes up for sale. In this case the manager's incentives to engage in earnings management are determined by how his earnings report affects his immediate compensation. Observability of his compensation contract is therefore critical to future generation's interpretation of his earnings report. When the manager is in office for longer periods (during which time the firm's ownership passes through multiple generations of shareholders), the manager's incentive to engage in income-smoothing is affected by the impact it has on his attempt to engage in intertemporal consumption-smoothing. Although most of the analysis of this latter situation is conducted under the assumption that the manager consumes what he earns each period, we show in an example that giving the manager access to capital markets need not eliminate his incentives to income-smooth. The reason is that engaging in intertemporal transfers via capital markets or, alternatively, via income-smoothing, is not a perfect substitute, and so the manager may find it advantageous to use both devices to transfer consumption intertemporally. The principal intellectual antecedents of this paper are Demski and Sappington [1987] and Samuelson [1958]. Demski and Sappington [1987] provide the modeling insight used here to investigate the feasibility of earnings management. Their idea that restricted communication channels can be an effective modeling device to vitiate the Revelation Principle is central to what follows. Overlapping generations models originated with Samuelson [1958] and have been used extensively to study monetary phenomena (see, e.g., Karaken and Wallace [1980]), but I am unaware of their previous use in an accounting context. Trueman and Titman [forthcoming] and Verrecchia [1986] contain alternative theories of earnings management. In section 2, I consider extensions of the single-period principal-agent model to illustrate pure forms of the internal and external demands for earnings management. In section 3, I merge the models introduced in section 2. Since the earnings announcement policies generated by the internal and external demands for earnings management may not coincide, I also examine shareholders' incentives to have management provide distinct public and private earnings announcements in section 3. In section 4, I present a multi-period principal-agent model to illustrate some income-smoothing phenomena. Section 5 concludes the paper and outlines an agenda for future research.

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2. Models of Pure Demand for Earnings Management

2.1 INTERNAL DEMAND

The model in this section focuses on the sequence of events illustrated in the time line in figure 1. This time line chronicles a standard principalagent problem, apart from the principal's inability to observe the manager's "output," the firm's actual earnings x. Instead of contracting on actual earnings, the principal must compensate the manager on the basis of his reported earnings. Absent restrictions on the relation between actual and reported earnings, the manager will exert no effort and simply announce that report which maximizes his compensation. But in fact there are restrictions on the relation between actual and reported earnings: internal and external auditors, audit committees, GAAP, and the law all serve to impose a relation between a manager's report and the truth. We summarize the web of restrictions on the manager's report imposed by these (and related) institutions via a "feasible reporting set," y(x; (). This set delimits the range of earnings reports y the manager can make, given that actual earnings are x and the manager's other private information (the purpose of which is described below) takes on the value e. The manager makes his report y after observing both x and e. As long as the manager's reported earnings y falls in the set Yix; t), the firm's owners cannot detect that the manager has misstated earnings; if y is outside Y{x; f), the owners learn that the manager's earnings report is false, although they do no learn anything else about actual earnings in that event. In addition to positing the existence of this auditing technology to constrain the manager's earnings management, I allow for the possibility that the manager incurs personal costs if he produces an inaccurate earnings report. These costs might include a distaste for lying, the educational costs of learning the firm's accounting system sufficiently well so as to be able to modify a component of earnings without having the modification be detected (or criticized) by the firm's auditor or the related costs involved in discovering how large e is (i.e., how large an error will not be detectable), or the costs involved in bribing an auditor not to report a discrepancy in the earnings report. Let c{x, y, e) indicate the cost to the manager of reporting that earnings are y when actual earnings are x and his other private information is e. I assume c{x, y, t)

Contract
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> 0 (i.e., the manager does not get utility from lying), and c{x, x, e) = 0 (truth-telling is costless). To complete the specification of the model, let U{d) - g(a) denote the manager's utility from consuming d and exerting effort level a E A = Ig, a]; let f{x\a) denote the density describing the stochastic relation between the manager's effort and earnings; let U be the manager's utility from alternative employment opportunities; and assume the owners of the firm are risk-neutral. We can study the internal demand for earnings management after establishing some definitions. DEFINITION 1. An earnings announcement policy is a function >'(, ) specifying, for every realization x and (, an announcement y{x, t). Throughout the subsequent discussion, announcement policies will be set with an underbar, whereas particular announcements will have the superscript'. Thusy is an announcement consistent with the policy yi, ) if there exists (x, t) with>' = >'(x, (). (Also, " denotes a random variable, whereas a variable without a ~ denotes the realization of the variable. Thus, X is a realization of x.) DEFINITION 2. An earnings announcement policy ^(, ) induces earnings management if, with positive probability, y{x, 1} does not equal
X.

This definition of earnings management is quite general and is likely to encompass any other definition of earnings management one might propose. In particular it should be noted that this definition, which can be applied in a multi-period context on a period-by-period basis, imposes no intertemporal restrictions on the relation between the time series of actual earnings and the time series of earnings announcements.' DEFINITION 3. Suppose current shareholders wish the manager to implement action a G A, and the only report the manager can make to shareholders is an earnings announcement. Then there is said to be an internal demand for earnings management provided every contract s(") which solves the program: Min ^[s(^(i, t))\a] (),.y(') subject to:
( 0 for all X, e, y{x, e) E arg m a x s{y) c{x, y, e), ( u ) a E arg m a x E[Uis{yix, {Hi) E[U(siy(x, ()) - c{x, yix, ()) - c{x, y{x, t ) , e)) \ a] - g{a) > U y E Y{x, t) d E A t ) , I)) \ d] - g{d),

induces the manager to engage in earnings management.

' Income-smoothing, which is typically considered to involve understatements of income followed hy overstatements (or vice versa), in contrast, does impose intertemporal restrictions on earnings. Income-smoothing is discussed in detail in section 4 helow.

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This definition simply recasts the description of an internal demand for earnings management given in the introduction; such demand exists if inducing earnings management is the expected cost-minimizing way to motivate the manager to select a particular action. (The counterpart to this definition when the manager can make an announcement t about the realization of his private information t, in addition to x, simply involves replacing y{x, c) by a joint reporting policy (yix, t), t(.x, t)) in the above program, with e{x, t) = e being interpreted as the manager's report of f.) In the sequel, the value of the objective function of this program when evaluated at its optimum is denoted by w{a). As previously noted, the Revelation Principle is a nemesis to the study of earnings management: when it applies, any contract which encourages earnings manipulation can be viewed as arbitrary, since another contract can be constructed which does not induce earnings management and which provides the same utilities to all contracting parties as the original contract. When the manager can communicate all dimensions of his private information (i.e., x and t) to shareholders, the Revelation Principle does indeed apply, and so no internal demand for earnings management exists. Thus, a necessary condition for the existence of an internal demand for management is that some dimension of management's private information cannot be costlessly communicated. This point has been made in various contexts by Demski and Sappington [1987], Green [1984], and Green and Laffont [1983]. Proposition 1 below shows that, apart from some mild regularity conditions, blocked communication of management's private information e is also a sufficient condition to generate earnings management. PROPOSITION 1. If (i) for every realization (x, t) of {x, t), the set y(x; e) contains a neighborhood of x; (ii) c(x, y, e) is differentiable in y in some neighborhood of j) = x, for every (x, t); (iii) it is prohibitively costly for the manager to report t, and so the manager's compensation depends only on his earnings announcement; (iv) the manager's optimal contract .s(") is differentiable in the earnings announcement; then there exists an internal demand for earnings management unless shareholders request the manager to select the lowest possible action a in A. Proposition 1 is based on the idea that if c{x, x, () is identically zero and dx, y, t) is differentiable in y at y = x, then the marginal cost of earnings management is zero in the vicinity of the true earnings x, i.e., very low levels of earnings management are essentially costless to the manager. Therefore, in order for the manager's contract not to induce some earnings management, the manager's compensation must be independent of his earnings announcement. But constant contracts are optimal only when the manager's optimal action is the lowest possible action. Thus, if shareholders wish managers to exert some nontrivial effort level, they must tolerate some earnings management. Note also that Proposition 1 is valid whether or not t is degenerate. This might appear to be inconsistent with the Revelation Principle

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because, when ( is degenerate and the manager announces a claimed value for i's realization, he is clearly reporting on all dimensions of his private information (there is only one dimension). To see what lies behind this claim, suppose Y(x; f) = (=, x + 1] for all x and f and siy) is strictly increasing in y. Then, the manager's optimal reporting strategy is 3'(x) = X + 1. But the contract six) = ,s(.y(x)), which usually corrects the reporting bias of a non-truth-telling contract, does not produce a truth-telling contract: since s(*) is increasing, so is ('), and hence the manager's optimal reporting strategy when compensated with () is also yi'). The Revelation Principle does not apply here even though the manager can report on every dimension of his private information, because the reporting set Yix; e) varies with the realization of x, i.e., his message space is partially blocked.' In addition, while the proposition states that earnings management must be tolerated to get nontrivial effort from the agent, it does not guarantee that any nontrivial effort level can be implemented by means of some contract which does result in earnings management.' However, obvious sufficient conditions for this latter result exist, e.g., suppose A is finite, x and e are discrete, Y(x; t) = (-co, x + e], and conditional on a E A, X + t's distribution possesses the concavity of distribution function condition and the monotone likelihood ratio property, and that there is no pair of distinct actions for which x + e's distribution is the same for each action. Then, for any action, a contract can be constructed to implement that action.^
2.2 EXTERNAL DEMAND

I now consider factors affecting the external demand for earnings management, while ignoring the moral hazard problem between current shareholders and management which gives rise to an internal demand for earnings management. That is, I assume that, upon being paid a wage w to cover his opportunity cost of employment, the manager will implement any earnings management policy requested by his employers, the firm's current shareholders. (To make this passive behavior rational for
-1 wish to thank Bruce Miller tor belpful conversations on this point. Also, anotber variation on this example is of some interest: suppose the manager's reporting set Y{x; t) consists of all real numbers regardless of tbe realization of x or f, and tbat he now experiences personal costs in manipulating earnings, as represented by c{x, y) = 'My - x)'-. If s(y) = y is the manager's contract and x = x occurs, tben the manager solves Max y V2{y - x)'^. Tbis bas solution y(x) = x H 1. It is easy to check that s(x) = s{y{x)) will not produce truth-telling, nor will tbe alternative "Revelation Principle" style contract s(x) s{y{x}) - c{x, y(x)). Tbe Revelation Principle fails here, not because of blockage of any message space (there is no sucb blockage), but rather because tbere are noncontractable costs of earnings manipulation. ' I.e., the proposition says tbat earnings n:ianagement is a necessary condition for effort exertion, but it does not identify sufficient conditions for effort exertion. I wisb to tbank Milt Harris for this observation. '' Tbe proof is available on request.

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the manager to adopt, I assume in this section that c{x, y, t) = 0 and that the action set A is the singleton [a].) This is an "overlapping generations" model (as in Samuelson [1958]); that is, two generations of shareholders, "young" and "old," coexist at each date, and the old transfer ownership of a firm to the young on a securities market. This overlapping generations framework highlights the distinction between current and prospective investorsand therefore generates an "external" demand for earnings management. In addition, this framework, together with the assumption that all old investors are risk-neutral in consumption, eliminates unanimity problems which typically arise when firms confront dynamic decision problems. In any period t of this model there are equal numbers of "young" and "old" investors. Each generation of investors lives for two periods. An investor born in period t gets utility c, -I- c,+]/(l -I- r) from consuming c, in period r, 7 = t, t + 1. Trade in a firm's shares, which transfers ownership from the old to the young, occurs after earnings are disclosed by period t incumbent management. Earnings announcements may influence the price the old receive (and the young pay) for the firm. Each generation contracts to have the firm run by new management, and each manager must be given a contract ,s() so that his utility from working for this firm is at least U, the (exogenous) utility obtainable through alternative employment. In this section, since the manager is assumed not to be subject to moral hazard, the contract ^s() is a wage w, where U{u!) g{a) = U. The (successive) managers' preferences and employment opportunities are assumed not to vary over time, and to be common knowledge to all investors. The time line in figure 2 provides more detail on the chronology of events in this model. The time line does not indicate the effects of passage of ownership of the firm to the young. Ownership of the firm entitles new shareholders (in period t, say) to two property rights: (1) the right to obtain proceeds in the next period from the sale of the firm to the next period's new generation {t + 1) of investors in proportion to the fraction of the firm purchased, and (2) the ownership of this period's actual economic earnings also proportionate to purchases. The second property right merits further explanation. Earnings generated by a manager hired in period t are assumed not to be transformed into consumables until after investors born in generation t have died, i.e., these earnings are consumed by investors born in generation t + I. This assumption accords with the idea that earnings may not be available for consumption purposes for substantial periods of time, and it introduces some intertemporal considerations even if earnings follow an independent and identically distributed {iid) time-series process. If the old generation sold the young generation the firm exclusive of currentperiod economic earnings, thenin an iid worldthe new generation of investors would be indifferent toward all earnings announcements, since the earnings announcements would contain no information regarding the

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economic value of the firm to them. Of course, when period t real earnings do become their property, they will be concerned with previous management's announcement of earnings, in which case earnings announcements will serve an allocative role, even in an iid model. One other note on the time line: even though members of the new generation observe only the previous management's announced value of earnings at the time shares are purchased, I assume that they (as well as the subsequently installed new management and all other future generations of investors) learn the actual value of economic earnings by the time they make their consumption/investment/contracting decisions. This assumption means that people ultimately learn the value of what they buy and that records of earnings are kept.' I also assume that the firm's actual earnings are distributed to shareholders and not reinvested in the firm. (Section 4 below introduces a model in which earnings may be retained at the manager's discretion.) To complete the specification of the model, I now describe the firm's stochastic production technology and the consequences of and the manager's opportunities for earnings management. f{x \ a) denotes the probability density (or mass) that next period's economic earnings will be x, given that the manager takes action a this period. That is, the earnings process in this paper is iid, conditional on the manager's action, although the results generalize to general Markovian processes (see Dye [1987J). The support X = \x\ f{x\ a) > 0\ of/is assumed independent of a. Let l{x, y, f) denote the corporate costs of earnings management, i.e., of reporting that earnings are y when actual earnings are x and the manager's private information is t, with l{x, x, t) = 0 and iix, y, f) 5: 0. The intent is to capture phenomena, like bond defeasance or intentionally stocking oul to dip into LIFO layers, which enhance reported earnings while potentially reducing firm value. Finally, as in the model of the internal demand for earnings management, I postulate that shareholders have access to an imprecise monitoring technology which allows them to discern whether earnings have been excessively overstated. All shareholders alive at a given date are assumed to be capable of discerning whether announced earnings fall into some set Y{x; t) (which contains a neighborhood of %). The central point concerning the external demand for earnings management made below is that the existence of this demand depends on the observability of current shareholders' instructions to their manager (regarding the firm's earnings management policy) to the next generation of investors. If these instructions are not (are) observable to the next
'This difference hetween announced and actual earnings is assumed to he correcltd retrospectively in the firm's records. Also, the analysis would change somewhat if consumption/investment decisions were made hefore economic earnings were known. In that case, earnings announcements would have an additional economic effect, and "truthful" earnings announcements would become more valuahlehy aiding in the early resolution of uncertaintv.

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generation of shareholders, there is (is not) an external demand for earnings management, irrespective of the manager's ability to communicate all dimensions of his private information to shareholders. These results are easy to explain. First, observe that if P(y) denotes the market-clearing price of the firm when the manager announces y, andy{, ) denotes his earnings announcement policy (e.g., if y{x, t) y, the manager announces y upon learning x = x, ( = f), and s(y) denotes the manager's compensation upon announcing y (under the present assumptions, siy) = w), then current shareholders (whose preferences are by assumption linear in second-period consumption) unanimously seek the manager to adopt the policy y(*) which maximizes:

subject to the constraints yix, t) G Yix, t) for all (x, e).*' Suppose current shareholders instruct their manager to adopt a "truthful" earnings announcement policy, i.e., y{x, f) = x. Then, the marketclearing price of the firm is: P{y) = y + i^/(i + r) for some constant v representing the value of the firm (exclusive of current-period earnings) to the next generation of shareholders (v is constant only in the case where earnings follow an iid process). Current shareholders' expected utilities from second-period consumption under this policy are given by: E[P{i) - six) I a] - E[x \ a] -h v/H + r) - w. Now suppose that the current generation alters its earnings announcement policy to, say, y{x, e), and that this alteration is observable to future generations of investors. Then the equilibrium pricing rule changes to, say, P("), satisfying:
P ( y ) = E [ x - l i x , y , e) \ a , y = y i x , ()] -\- v/{l -h r ) .

' To see that all shareholders desire to maximize E\l^ .s], consider a shareholder born in period t who has initial wealth W, purchases fraction 6 of the firm (in period () whose market price is P,, and learns that the firm's "net" economic earnings in period ; are:
Xi"
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i'l,

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If he invests / dollars in a riskless asset which returns (/ + r)/in period ( + 1, and consumes cv in period T = t,t + I, then his consumption/investment opportunities are given by: c, + I ^ W+ 0{xr - P,)

where .s,+ i is tbe contract his generation offers to tbe firm's manager. It is clear that, regardless of the choice of c, or /, the investor wishes s,,, to be chosen to maximize E[ P, +, - s,+ t], as long as his position f) in the firm is not negative.

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(v does not change because it is determined by the next generation's behavior.) Current shareholders' expected utilities from this revised policy are equal to:
E[Piyix, t)) - siyii, e)) | a] = E[i - Hi, yjx, e), f) | a]

+ u/d 4- r) - w < E[x I a] -I- v/il + r) - w. (The inequality follows from / > 0.) Hence, when current shareholders' earnings announcement instructions are observable to future generations of investors, current investors do not profit by deviating from a truthful earnings announcement policy. This result has been demonstrated for the case where the manager does not communicate t; exactly the same argument applies when the manager does announce e. The intuition for this result is clear: deviating from a truthful earnings policy is not beneficial because (1) prospective shareholders revise their demands for the firm's shares (thereby altering the equilibrium pricing policy) as current shareholders publicly change their earnings announcement policy (i.e., prospective shareholders do not exhibit functional fixation) and (2) earnings management may be costly (/(x, y, 0 > 0), whereas truthful earnings announcements are free {l{x, x, t) = ()). If. however, prospective shareholders cannot observe current shareholders' earnings announcement instructions to their management, a truthful earnings announcement policy is not consistent with equilibrium hehavior by current shareholders. Before proceeding with the proof of this claim, I define formally the notion of an equilibrium for this case. DEFINITION 4. A stationary equilibrium associated with unobservable earnings announcement instructions in the absence of managerial moral hazard consists of a pricing function Pi*), an earnings announcement policy y(), and a constant v such that:
ii) F o r e a c h . y , P{y) = E{x - Hx, y , t) \a, y = y ( i , f ) | + v/il + r) Hi) iiii) EjPiyix, r F o r e a c h ix, t ) , yix, 0 G a r g m a x P ( y , (), y E Yix; t ) . e)) - w\

Conditions (0 and iii) assure that the market-clearing price of the firm equals the sum of expected current and discounted cash flows, conditional on the manager's actual announcements y and the announcement policy yl', ) future shareholders believe current shareholders requested to he implemented. Condition iiii) distinguishes this case from the case above: since future shareholders cannot observe current shareholders' instructions to their management presently, current shareholders attempt lo exploit this informational asymmetry by selecting their earnings announcement policy optimally, taking future shareholders' beliefs--and

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hence, the functional form of the equilibrium pricing function P(*)as given. Of course, in equilibrium, future shareholders are not fooled, as (iii) indicates: their beliefs turn out to be correct. It is now clear why the truthful earnings announcement policy y{x, t) = X cannot be part of an equilibrium, as long as Y{x; t) contains a neighborhood of points around x, for each (x, t). If prospective investors believed that current shareholders adopted a truthful earnings policy, then the market-clearing price would be given by: Piy) -y + f^/(i + ^)Since current shareholders can implement any earnings announcement policy y{', ) which satisfies y(x, 0 E Y{x; e) for all (x, 0 without prospective shareholders detecting their deviation from a truthful earnings announcement policy, current shareholders will maximize their utility by having management select y(x, t) = Sup Y{x; e). Thus, a truthful earnings announcement policy cannot be part of any equilibriumand this is true independent of the corporate costs of earnings management. The intuition here is also straightforward: since modifications in earnings announcement policies are unobservable to potential investors, earnings management is irresistible to current shareholders interested in maximizing the firm's current market value. Although this argument was presented assuming that the manager announces only y, exactly the same argument applies when announcements of e are allowed. In summary, we observe that the internal demand for earnings management is driven by the inability of managers to report all dimensions of their private information, whereas the external demand for earnings management is driven by the inability of current shareholders to report the earnings announcement policy they instruct their management to adopt to future shareholders. 3. An Integrated Model of Earnings Management

In practice, it is probably rare to find pure forms of either internal or external demands for earnings management. Shareholders may be concerned about both the cost of getting managers to adopt their preferred actions as well as the external effects of the earnings announcement policies induced by management's compensation schemes. In this section, I illustrate what happens when these demands for earnings management are merged. The time line for the merged model is identical to the time line in figure 2 above, which depicts the sequence of events for the model illustrating an external demand for earnings management. The feature distinguishing the merged model from the "external demand" model is that the manager is now subject to moral hazard, and so must be

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motivated to choose the appropriate action and earnings management policy by judicious design of his compensation scheme. Also, just as the observability of the manager's earnings announcement instructions influenced the external demand for earnings management, so does the observability of the manager's contract affect the demand for earnings management in the merged model. In the following definition of equilibrium, "unobservable management contracts" is shorthand for "the contracts offered by one generation of shareholders to their manager are not observable to the next generation of shareholders." The interpretation of "observable management contracts" is analogous. (These two notions of equilibrium are sometimes referred to as OCK and NCE, short for observable and nonobservable contract equilibrium, respectively.) DEFINITION 5. A stationary equilibrium associated with unobservable management contracts (NCE) consists of a pricing function P(), an earnings announcement policy 3'(, ), an action a*, a contract s*(), and a constant v such that:
( 0 For each y, P{y) Ul) u = E[P{yii, = E[i - l{i, y, 0 \a*,y = y(x, ()\ + v/i\ + r) -,))]

0 ) - s*(y{i,

(iii) Taking P(-) as given, >'(), -s*(), and a* maximize E[P{y(x, - siyix, t))\ a] among all y(), .s(), and a satisfying: (a) for all x, e, yix, e) arg max U(s{y) - eix, y, t)),

0) y

Yix; ,)
ib) a m a x i m i z e s [ ( / ( s ( y ( i , e)) - dx, yix, A ()) -cix,yii, f), t ) ) i a ] - ^ ( a ) > U. t))\d] gid) a m o n g all din ic) E[U(siyii,

This equilibrium is similar to the one defined in section 2.2 above: {i) and iii) state that the value of the firm is the discounted sum ol' its expected actual earnings; (iii) states that the old investors of any generation seek to maximize the expected value of the firm net of the expected cost of management compensation, subject to the manager's willingness to work for the firm (condition iiii)ic)) and implement the proposed earnings announcement policy (condition iiii){a)) and action (condition iiii)(b)), while taking as given prospective investors' perceptions of the current manager's contract/action/earnings announcement policy (and therefore the functional form of the pricing function Pi')). The formal definition of an OCE differs from the definition of an NCE presented above in the specification of the market-clearing pricing function. In an NCE, this function can depend at most on the current

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manager's earnings announcement. In an OCE, this function also depends on the current manager's contract. Consequently, in an OCE investors know (rather than conjecture) what earnings announcement policy the previous generation's manager adopted, and so the market-clearing price function will change as the manager's earnings announcement policy changes. This is modeled by substituting: P(y I y(*)) = E[i - lix, y(i, I), I) I a, y = y^d, e)] + u/(l + r) for P{y) in the definition of equilibrium, where y is to be interpreted as the earnings announcement policy induced by whatever contract the previous generation gave their manager. Proposition 2. (a) If: (/) f(x\a) and w{a) (the minimum expected cost of getting the manager to take action a) are continuous in a, for each a E A = [a, d], and the set X of possible realizations of x is finite; (ii) c"= 0; / = 0 and Y{x; e) ^ (-oo, x + t] then there exists an equilibrium associated with observable management contracts, with the earnings announcement policy y{x, e) = x + e. (b) If, in addition to (0 and (ii): (iii) f's density defines a scale parameter family with the monotone likelihood ratio property;" (iv) Fix I a) is convex in a, where F(- | a) is the cumulative distribution function associated with /( | a);" (v) u;(a) is convex in a; then there exists an equilibrium associated with unobservable management contracts, also with the earnings announcement policy y(x, f) =
X -H e.

Three remarks about this proposition follow. (1) Under the assumptions of Proposition 2 and both notions of equilibrium, managers make the largest earnings announcement possible which is not discernibly false.'' This result occurs for two reasons. First,
A family of density functions \fix\ll}\e ^ il\ indexed hy some ordered set Si possesses ^ the monotome likelihood ratio properly if fix \ O)/f{x \6') is increasing in x for 0 greater than e'. This family of density functions is a "scale parameter" family if/(A:| d) = f{x - 0) for each 6 and x. (See Lehmann [1959].) Milgrom [1981] shows that, if appropriate differentiability conditions hold, a family possesses MLRP if/(x [ fl)/f(x \ 0) is increasing in X (subscripts denote partial derivatives here). Consequently, if i(*) is e's density, then I'U)/ lU) is decreasing in e when /() defines a scale parameter MLRP family. This fact is used in the proof of Proposition 2. " Condition (iv) is also referred to as the concavily of distribution function condition; see, e.g., Grossman and Hart [1983]. " Unfortunately, I do not know of sufficient conditions which guarantee that these announcement policies are unique.

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it is easy to show when c = 0 = / and Y(x; e) = (-00, x -- e], that among the contracts which induce the manager to adopt any particular action a at lowest expected cost, there exists a contract which is increasing in the manager's reported earnings.'" Given such a contract, the manager is obviously motivated to make the largest possible earnings report. Because the next generation can observe this contract in the case of an OCE, this fact is itself sufficient to guarantee that an OCE equilibrium exists with the announcement policy y{x, () ^ x -\- t. For an NCE, one must also observe that, since there are posited to be no corporate costs of earnings management (^ = 0), the market-clearing price of the firm is an increasing function of E[x \ a, yix, e) = y], i.e., of current expected earnings, conditional on the manager's earnings announcement policy, action choice, and actual earnings report. When future investors believe the manager always makes the largest earnings announcement possible (y{x, t) = x + 0, it can be shown that the current-period expected earnings are an increasing function of reported earnings, when I's density defines a scale parameter MLRP family. Consequently, the market-clearing price of the firm is an increasing function of the earnings announcement, so current shareholders prefer the highest possible earnings announcement. In brief, given the assumptions of Proposition 2, the earnings announcement policy which maximizes the market value of the firm coincides with the policy which minimizes the expected cost of getting the manager to adopt current shareholders' preferred action. This common policy consists of having the manager always make the largest possible earnings announcement (i.e., adopt the least conservative reporting policy) under both equilibrium constructs. (2) More hypotheses are employed to establish the existence of an equilibrium associated with unobservable contracts (those in Proposition 2.2) than for observable contracts (those in Proposition 2.1) because, in the former case, the prospective investors have to make conjectures about what contract current shareholders have offered their manager which, in equilibrium, turn out to be correct. No such conjecturing is necessary when contracts are observable to prospective investors, and so an equilibrium exists under fewer restrictions in that case. (3) Though the earnings announcement policies for both equilibrium constructs are the same, other aspects of the two equilibria differ. Explicitly, if we add to the list of hypotheses in (6) that \f{x\a)\a t A\ is an MLRP family and that f{x \ a) is differentiable in a, we can show that the equilibrium action associated with the observable contract equilibrium (which maximizes E[x \ a] - w{a)) is greater than the equilibrium action associated with the unobservable contract equilibrium, and, hence, the expected market-clearing price of the firm is higher with
" T h i s result holds even for some cost functions (() which are not identically zero. Specifically, as long as c(x, y, i) is nondecreasing in y, the result follows.

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the OCE than with the NCE. The reason for this ordering is clear: under an NCE, any modification in a manager's contract which induces him to increase his action generates a positive externality for future shareholders for which current shareholders are not compensated, because the marketclearing price cannot depend on the contract offered in an NCE. Clearly, no corresponding externality exists under an OCE. In tbat case, future investors pay for any change current investors make in their manager's contract which increases the manager's preferred action. In both equilibrium constructs, the next generation of shareholders correctly assesses in equilibrium the contract the prior generation of shareholders gave to their management, so it might seem that there should be no differences in the social welfare obtainable from these alternative equilibrium notions. In fact, it can be shown that the allocations associated with an OCE generally strictly Pareto dominate those associated witb an NCE. This can be explained by viewing the three sets of economic actors (tbe "next" generation of shareholders, the "current" generation of shareholders, the "current" manager) as all being members of a hierarchically organized firm, with the "next" generation at the top of the hierarchy, the "current" generation in the middle, and the current manager at the bottom. From this perspective, the current generation of investors is an agent of the next generation, and the action they take consists of the selection of their manager's contract. Now, as is true in any agency relationship, the principal is (typically strictly) better off if he can observe his agent's action. In particular, future investors are better off here if they can see the action (i.e., the contract) their agents (current investors) select. The strict Pareto superiority of observable management contracts over unobservable contracts is puzzling in view of the relatively sparse information contained about management contracts in proxy statements. What could account for this? One answer is technological; it may be infeasible to describe all details which determine the (present value of the) manager's compensation, since the evolution of his contract from one period to the next is affected by myriad, often unanticipated, factors. An alternative explanation for the absence of observable management contracts comes from consideration of strategic interactions among firms. Fershtman, Judd, and Kalai [1987] show that the ability of firms to engage in collusive behavior increases when their firms' managers contracts are observable to other firms. (Katz [1987] studies a related model.) When collusive behavior is socially undesirable, prohibitions against producing publicly observable contracts may be welfare-enhancing. Whether these desirable effects of unobservable management contracts persist when the strategic context of Fershtman, Judd, and Kalai [1987] is combined with the setting of this paper^where contract observability produces a positive externalityremains an open question. Finally, given the differences in welfare attainable between NCE and

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OCB equilibria, one might expect that future-period investors would have incentives to expend resources to discover the (functional form of the) contract between current-period investors and their manager. Surprisingly, if any future investor cannot sell what he learns about the contract to other future investors (and hence, can use what he learns only to modify his own investment decisions), then no investor will pay any positive amount to determine the contractual relation between current investors and their manager. The reason is that, in equilibrium, the investor can infer what contract is offered. Hence, by incurring costs to observe the contract, the investor only confirms what he previously inferredand so observation of the contract does not improve the investor's knowledge of the relation between the firm's report and the underlying value (x) of the firm. Consequently, no utility-maximizing future-period investor would every pay these costs of confirming the current-period manager's contract. Thus, there may be a role for mandated disclosure of the details of management (and related) contracts, a role which is examined in Dye, Balachandran, and Magee [1987]. We should not expect the earnings announcement policies generated by the internal and external demands for earnings management to be always as closely aligned as they are under Proposition 2's hypotheses, or to be independent of the observability of management's contract to subsequent generations of investors. In Proposition 3 below, we explore the potential for differences in earnings announcement policies arising from these distinct sources of demand for earnings management, by giving managers the opportunity to issue two earnings announcements, one private (to current shareholders) for purposes of performance evaluation and compensation, and one public, designed to influence prospective investors' perceptions of the value of the firm. The results presented in Proposition 3 below depend on how the manager's personal cost of earnings management c(x, y, e) and the corporation's cost of earnings management l{x, y, t) vary with the manager's private and public earnings announcements. In this proposition, we posit that the managers' personal cost of earnings management depends on their private reports, since they can be expected to bear some personal costs whenever they alter their private earnings announcements to influence their compensation. Whether these private announcements also generate corporate costs of earnings management is case-specific, e.g., altering the timing of the recognition of revenues and expenses to affect the private earnings figures may be costless to the corporation (excluding the effect on management compensation), whereas altering the firm's inventory policy for the same purposes may be costly. Consequently, we analyze separately the cases in which the corporate costs of earnings management are affected by the manager's private announcements or his public announcements. PROPOSITION 3.1. When management contracts are publicly observa-

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ble (the OCE case), and when both the corporate (/) and management ic) costs of earnings manipulation are a function of the earnings announcements made in private, then no generation of investors obtains any advantage by having managers issue distinct public and private earnings announcements. PROPOSITON 3.2. When management contracts are publicly observable (the OCE case), and when the corporate costs il) of earnings manipulation are a function of earnings announcements made in public, whereas the management costs (c) of earnings management are a function of earnings announcements made in private, investors may seek to have distinct public and private earnings announcements. In particular, under the additional hypotheses of Proposition 1 above, earnings management in private will occur, although there will never be any manipulation of public earnings announcements when [(x, y, t) 9^0 for y ?^ x. PROPOSITION 3.3. Suppose that, as in Proposition 3.1, both the corporate and management costs of earnings management depend on the manager's private earnings announcements. If C2(x, x + t, e) = oo, then for any stationary NCE whose current-period market-clearing price is strictly increasing in the current-period earnings announcement, the current generation of investors will have their manager issue distinct public and private earnings reports. Proposition 3's conclusions follow directly from the rationality of future generations of investors. When management contracts are observable, current investors do not fool future investors by having distinct public and private earnings announcements when all costs of earnings management derive from earnings announcements which future investors do not see. In this case, future investors use the public earnings announcement solely to update their knowledge of both the realized value of X and the actual corporate costs of earnings management; on average, their expectations will be correct and the amount they will pay for the firm will be independent of whether the public earnings announcement policy is distinct from the private earnings announcement policy. In this case, public earnings announcements are known to be purely "window dressing" subject to the informational constraint y t Y{x'; e). In contrast, when the corporate costs of earnings management arise from public earnings statements (though management costs of earnings manipulation remain a function of earnings statements made in private), current investors can profit by proposing distinct public and private earnings announcement policies. In view of the rationality of future generations of investors, current investors can do no better than offer their manager incentives to reduce the corporate costs of earnings management to zero (e.g., by adopting a policy of no public earnings management), regardless of what private earnings announcement policy they seek to implement. Since we know from Proposition 1 that, for earnings announcement policies which affect the manager's compensation, a policy

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of no earnings management is typically not feasible, it follows (in this case) that public and private earnings announcement policies generally will not coincide. Comparing Proposition 3.1 and 3.3, we conclude that the observability of management's contract to subsequent generations of investors also affects the desirability of issuing public and private earnings announcements. This is not surprising. When current management's contract cannot be observed by potential investors, current shareholders will disregard the effects of their choice of compensation schemes on the corporate costs of earnings management (and hence, on the marketclearing price of the firm) induced by the management's private earnings announcements. Instead, investors' optimal private earnings announcement policy will be chosen to minimize only the costs (which they bear) of getting their manager to select their preferred action. The public announcements will be chosen solely for their impact on the firm's price, i.e., for any fixed x, t, the public announcement y will satisfy: P(y) = Max P ( y ) , y < x + t. (i)

The policy which attains (1) will not coincide typically with the private earnings announcement policy which minimizes the expected cost of getting the manager to adopt current investors' preferred action. Although not presented here, a result similar to Proposition 3.2 holds for NCE. These and related results are summarized in figure 3. 4. Income-Smoothing

4.1 MODEL DESCRIPTION

In this section, I present a model in which managers have two periods of tenure in order to study earnings management which involves shifting reported income across periods. This model is significantly more complex than the one studied earlier for two reasons. First, successive time periods are no longer symmetric in that periods differ depending on how long a manager has been in office. Second, the number of decisions the manager must make increases geometrically with the length of his tenure in office. What insight does this additional complexity reveal? The principal result here is that, under very mild assumptions, income-smoothing (i.e., overstated earnings are followed by understatements, or vice versa) is inevitable when investors are incapable of determining the firm's periodic economic earnings. We begin with an explicit definition of income-smoothing for a manager whose first earnings announcement occurs in period fl. DEFINITION 6. A two-period announcement policy y,-,( I, y,( ) induces income-smoothing if, with positive probability:
y , _ i ( % , _ ] , t , - i ) < x,-y a n d y , ( x , - i , x,, t,..,) > x, o r y , _ . , ( x , - , . t , - i ) > .x,-i a n d y , ( x , ,, x , , e,..,) < x,.

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215

c, / both based on private earnings announcements

No advantage to distinct reports; Common report (for chosen action) minimizes

E[s + I] (x' ^ y ^ x' +
t'}

Advantage to distinct reports; Public report maximizes market-price; Private report (for chosen action) minimizes
E[s] {y^x' +*') Same as above

c based on private announcement; / based on public announcement

Advantage to distinct reports; Public report is truthful; Private report (for chosen action) minimizes
E [ s \ {y = x - )

FIG. 3.Factors contributing to current investors' desire to have management issue distinct public and private earnings announcements. The last expression in each box is the optimal public earnings announcement in the case where c(*) and /() are both increasing in y when the market-clearing price of the firm is increasing in the earnings announcement, for a given realization {x', t'} of {x,, f,). For the results in the NCE boxes, cjx, x + f, i) = cc is assumed.

Earnings management as defined in Definition 2 is a necessary but not sufficient condition for income-smoothing as defined here. Earnings management involves misstatements of income, whereas income-smoothing requires understatements (or overstatements) of earnings to be followed by overstatements (understatements). The model setup is as follows. We assume, initially, that the manager consumes what he earns in each of the two periods he is in office (this latter simplifying assumption is used in much of the multi-period agency literaturesee, e.g., Lambert [19831 or Rogerson [1985]). New managers are installed in even-numbered periods. If t is even, Xt+, denotes a realization of the firm's economic earnings in period t -\- 1 arising from the new manager's first action choice a, (in period t). As in previous sections, the manager's period t -\- 1 earnings announcement yt+i is constrained by yt+i < i+i + e^+i, where e,+i is the realization of some random variable privately observed by the manager. For income-smoothing to be viable, investors born in period t + 1 must not learn the actual value of x,+i subsequent to hearing the manager's report and purchasing shares in the firm. This poses a serious problem: what utility do these investors get from owning the firm, apart from its exit value? One could assume these investors have (loosely speaking) rational expectations and that they get utility from the expected value of the firm's actual earnings of period t + 1. But this is not methodologically acceptable because all investors' utilities from ownership should be derived from their utilities over consumption. Instead, I shall assume that the manager in period t + 1 actually distributes earnings in period t -I- 1 to the young investors of that period in an amount equal to his

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earnings announcement for that period. Therefore, I assume that investors of generation ^ -I- 1 get utility from this explicit distribution of the firm's earnings as well as from selling the firm to the next generation of investors. Thus, the period t + 1 earnings announcement is, for all intents and purposes, a declaration of dividends. The manager takes another action a,.n in period t + 1 (which will depend typically on the realization x,+, and the announcement v,+ ;), thereby generating a distribution for x,+^, the firm's period t + 2 earnings. In period / + 2, the manager makes another earnings announcement y,+:!Clearly, the range of feasible announcements y,+. should depend on the actual period t + 2 earnings x,+2 as well as any undistributed (or, if negative, overstated) earnings x,+, - 3), + , of period t + 1. There are a variety of ways to combine these constraints. I shall assume y,.-j< x,^, + x,-t2 yi+i. That is, I assume (cumulatively) conservative earnings announcements are undetectable, whereas overly liberal announcements are found out.'' Subsequent to purchasing the firm, investors born in generation t + 2 learn the actual value of the sum of period t + 2 earnings and previously undistributed earnings x, ,2 + x,+ i - 3}^,, and then they hire a new manager and the cycle repeats itself In every even-numbered period t (when a new manager is hired), the investors born in that period learn X,, whereas in every odd-numhered period, investors born in that period learn about that period's actual earnings only by gleaning information from the manager's reported earnings. This artificial cyclical asymmetry in investors' knowledge of the firm's actual earnings is just a simple way of approximating the more typical situation in which investors' knowledge of the firm's financial condition varies over time (due, say, to the time elapsed from the firm's last audit). A (new) manager hired in period t has time-separable preferences summarized by U(c,+ i) ~ gia>) + fi[iUic,+2) - gia,+i)], when he takes action o, and consumes c,+i, tor T = t, t + 1. fi is his personal discount rate. Most of the rest of the model's description is contained in figure 4 and points (l)-(6) below. These six points explain the equilibrium in a "hackward dynamic programming" format: the last thing the manager does in his second period in office is described in point (1), next to last in point (2), etc.
" Notice that, in contrast to tbe assumption made for period ( + 1,1 assume no private error term, f,,,,, exists. One story for tbis runs as follows: while a manager is m office, he may have the option of shifting income across periods. In the manager's last period in office, however, the manager may have to "put his house in order": unjustified accruals could be detected by the newly installed management and result in tbe previous manager being punisbed. Alternatively, tbis could be considered as tbe defining condition of a conservative "income recognition" rule, in which cumulative income recognized does not exceed cumulative casb flows over long enough time horizons. See also Antle and Demski [forthcoming].

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Period t + 2 earnings management policy. (1) Taking the previous period's actual earnings x,+ i and reported earnings y,,, as given, upon learning period t + 2's actual earnings :c,+2, the incumbent manager chooses his utility-maximizing last period report y,+,, subject to the constraint y,+ , +y,+. < x,-+, + x,+2. Period t + 1 action policy. (2) Taking the reporting strategy described in (1) as given, the incumbent manager chooses his last-period action a,-M optimally, conditioned on the previous period's actual earnings and reported earnings. Period t -\- 1 earnings management policy. (3) Taking his last-period action and earnings management policies as given, upon learning the periods + 1 values of %,+i ande,+ i, the manager chooses reported earnings yt+i to maximize the sum of his current period and discounted expected next-period utilities, while also considering the dependence of his period t + 2 contract on his period t-\-l earnings report, subject to the constraint
yi+t < x,+i + (,+].

Period t action policy. (4) Taking the policies described by (l)-(3) as given, the manager's initial action choice maximizes the discounted sum of the expected utilities over the two periods he is in office. Contract choice. (5) Taking the manager's behavior (as described by (l)-(4)) as given, each generation of investors selects the contract for the manager which maximizes the expected proceeds they receive from the sale of the firm to the next generation of investors net of the manager's compensation, while taking the contracts of all other generations as given, subject to the contraint that, regardless of the realizations of any random variables, the manager's periodic expected utility is at least 0. Consistent expectations. (6) The behavior of each generation of investors and managers coincides with the behavior other generations of investors and managers perceived that generation would adopt, and the pricing rules are correct (i.e., they satisfy recursions analogous to those in the definition of an unobservable contract equilibrium in the previous section).
4.2 ANALYSIS

Proposition 4 provides sufficient conditions for income-smoothing to occur.

PROPOSITION 4. If: (i) c=l = O;

iii) no generation of investors ever seeks to have their firm's manager exert the minimum possible effort level; (iii) every optimal earnings announcement-contingent contract is differentiable in the earnings announcement; iiv) no generation of shareholders can commit subsequent generations of shareholders to adopt previously defined management contracts;

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(v) the earnings process \x,\ satisfies:

x,+i = ax, + /32,+i + <l>i+i, where Zf-,-1 ~ q{zt+i\a), \<t>t\ is iid, a > 0, a n d

\q{zt+i I a) I a ( A j is an MLRP family; then income-smoothing occurs in every NCE and every OCE where managers have two periods of tenure, even if {I, \ is degenerate, provided the manager's discount rate ii is sufficiently close to one. The proposition illustrates that income-smoothing may be expected to occur for several time-series processes. The essential idea of the proof can be conveyed by considering the case where Xi is iid. It can be shown that, for income-smoothing not to occur in this case, the manager must distribute all of the firm's earnings to shareholders at the end of his first period in office. If he does so, the optimal one-period contract the "next" generation of shareholders will offer the manager is the same as the oneperiod contract his first employers offered. The reason is that the manager is endowed at the start of both periods with the same production technology and the same (zero) initial level of undistributed earnings. But, if the manager is offered a sequence of identical one-period contracts, he will be tempted to engage in income-smoothing to achieve (personal) consumption-smoothing, so the assumption that income-smoothing does not occur leads to a contradiction. Insight into the causes of income-smoothing in Proposition 4 can be obtained by considering the "internal" and "external" demands for smoothing when the time-series process is iid. If the manager's discretion in action choice is eliminated, an external demand for income-smoothing derives solely from shareholders' attempts to increase the price of the firm by distorting the earnings reports. For even integers t, the constraint y(+i + yt+2 ^ Xi+\ + ^1+2 prevents the manager from overstating the sum of period t-l- 2 earnings (x,+:!) and previously undistributed earnings {x,+i - y^+i)- Consequently, in the iid case, the period t + 2 market-clearing price of the firm will be strictly increasing in the report yt+2, so the old investors of generation t + 2 will want their manager to announce the largest report possible. It then follows that income-smoothing occurs over the time interval t + 1 to f -t- 2 if and only if earnings management
occurs int + 1, since yt+2 = Xi+i + x,+2 y,+ i implies yt+2 ^ Xt+2 as y,+ , ^

x,+i. But, the question of when the old investors in t -I- 1 wish their manager to engage in earnings management is the one-period problem analyzed in section 2, so we have the following result. COROLLARY 1. If, in the model of this section, the manager has no discretion in action choice, the earnings process is iid, and for each t, Xt, and ,, Yixr, t,) contains a neighborhood of x,, there is an external

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RONALD A. DYE

demand for income-smoothing if and only if the earnings announcement policy investors instruct their manager to adopt during his first period in office is not observable to subsequent generations of investors.'" The existence of an external demand for income-smoothing does not provide a complete explanation of Proposition 4, because Proposition 4's conclusions are not predicated on the observability of the manager's announcement policy (more generally, contract). So we now consider the influence of the existence of an "internal demand" for income-smoothing. There are two principal differences between the definition of an internal demand for income-smoothing and the definition of an internal demand for earnings management introduced in section 2: first, it is defined with reference to the manager's implementation of a two-period action policy; second, to be consistent with the assumption maintained here that one generation of investors cannot precommit subsequent generations to contracts with their manager, we assume that the two-period contracts which induce the manager to adopt a particular action policy are chosen sequentially, each subject to the restriction that the manager's periodic utility exceeds U. To study the internal demand for income-smoothing, we make use of the following lemma. Lemma. Given any two-period contract S/+i(y,>i), s,+^ (>',+ > which gets ) a manager to adopt the action policy (a,, a,+ i), there exists another second-period contract ,9,"+2 such that the contract pair ,s,+ i, s',+-> (1) provides both shareholders and the manager the same utilities as they obtained under the original contract pair, (2) implements the action policy (a,, a,+]), and (3) sl^-, is increasing in y,+2. The lemma states that, by evaluating contracts only in terms of their expected costs of compensation, no generation of shareholders is made worse off by giving the manager a contract which is increasing in his report for his last period in office. Consequently, no generation of shareholders' cost of compensating the manager is increased by assuming that the manager implements the second-period announcement policy y,^,^ ^ x,+ i -I- x,+v yi-n. But, from the preceding discussion, we already know that the exit value of the firm to the old shareholders in period t -F 2 obtained by using this announcement policy yi.f.2 is strictly higher than with any other policy. These two results establish the unique optimality of the policy y,., 2 = x,+ i + Xi+.> - y,+ i in the original problem regardless of the observability of the manager's contract. As was noted above, if the period t -h 2 contract takes the form y^ j (as just defined), income-smoothing does not occur over the interval t + I to t -\- 2 if earnings management does not occur in t 4- 1. In that case, the manager starts his contract with investors born in / -I- 1 without any
'- Corollaries 1 and 2 and the following lemma are proved by using arguments similar to those used to prove Proposition 4 and are not reproduced here.

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undistributed earnings, just as at the start of t. Hence, whatever action was optimal for the generation born in t to induce the manager to implement must similarly be optimal for the generation born in t + 1, and both generations offer the manager the same contract. However, offering such a pair of identical contracts produces income-smoothing by the manager. Specifically: COROLLARY 2. If a manager is given the same nonconstant contract in each of two successive periods t + I, t + 2 and Yix,+u ft-n) contains a neighborhood of x,+ , for each X,M, then he will engage in incomesmoothing provided his discount rate is sufficiently close to one. This corollary depends on the separability and time-stationarity of the manager's preferences. If the manager's second-period utility from consumption depends on his first period's consumption, or deviated in some other significant way from his utility for consumption in the first period (as would be true if his discount rate were significantly different from one), then the corollary might not hold. In summary, we see that "external demand" concerns preclude incomesmoothing only if no earnings management occurs at the end of the manager's first period in office. This, in conjunction with the stationarity of the environment, makes each generation of investors request the manager to adopt the same action choice. Finally, we note that any efficient contract pair which induces the manager to select this constant action policy and the second-period earnings announcement policy ^,+^; generates an internal demand for income-smoothing. So the incomesmoothing documented in Proposition 4 rests on the interaction of internal and external demands for income smoothing. Proposition 4 is explicit in not requiring the manager to experience blocked communication of either t, or his compensation scheme for income-smoothing behavior to emerge. Blocked communication is not crucial here, although it was in previous sections, because no generation of shareholders is presumed to be able to precommit other generations of shareholders to multi-period management contracts. If they could enforce such contracts, then the conditions under which the Revelation Principle would not apply (i.e., income-smoothing would prevail) would consist of the same blocked communication conditions discussed in previous sections. Without the protection obtainable from multi-period contracts, the manager may not be willing to reveal earnings truthfully, even if no communication channels are blocked because the manager could anticipate that earnings disclosures might affect the design of subsequent management contracts and thereby adversely affect his expected utility.
4.3 EXAMPLE

The demonstration in Proposition 4 that income-smoothing must occur does not provide much indication of what form the income-smoothing

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will take. The following example illustrates a two-period manager's optimal income-smoothing behavior.'' Let a two-period manager born in period t have time-separable utility function (./(c,+ i) g(a,+,-t) = a:c,+ i 57+1 fcaf+,-i,for positive constants, , <5,/?, and i = 1, 2 (f/(-) is defined for c,+ i < a/25). Let his time discount factor be /i, and assume his production technology for earnings is iid, with mean F[xt+, | a,,,_i] = ai+i-i and variance a^ independent of a,+/-i. In this example, attention is confined to (probably suboptimal) linear compensation contracts of the form s,+, (y,+i) = *,y',+, -I- ^,, where y,+; is the manager's reported earnings in period i; *2 and ^2 can depend in principle on the manager's earnings report in period t -I- 1. There are assumed to be no intergenerational contractual precommitments. Also,
as above, y^+i < x^,^, + t,+ i,y,+2 < x^.,.i -I- X,+L> >V+I- Finally, there are no

costs of earnings management: c ^ / ^ 0. When investors born in period t wish the manager to adopt a nontrivial level of effort, an equilibrium management policy is described by a function y,.n (x,+i e^+i) specified by: y, if x,+i -I- e,+ i > y for some constant y, provided the support of et+i is [0, e] for some e < oo. Upon reflection, this is exactly what one should expect, given the restriction on the period t + 1 earnings announcement:

If the present value of the manager's expected utility is a concave function of his current-period report y,+i and (x,+ i, f,+j) occurs, then the manager always has the option of reporting any y,+ i < X(+] -I- t,+i. If the manager finds it optimal to report a lower-value y,+i than the largest possible value {xt+\ -I- (,+i), then it must be because the marginal utility he derives from any higher earnings report is zero. It must follow (by concavity) that for any realized values of x,+ ^ 4- e,+ i higher than Xf+\ + t,+ ,. the marginal utility of any report higher than y,+\ is still zero, so, beyond some point, higher realizations of x,4i + e,+ i do not alter the manager's most-preferred earnings report. In contrast, for low values of x^-,^ + fn\, the manager's optimal report will "bump up against" the constraint y, +, < XH ) + f;+i because (again by concavity) the manager's utility from higher reports is increasing for low values of y,-fi- Consequently, the example can be viewed as simply illustrating sufficient conditions for the manager's discounted expected utility to be a concave function of his first-period earnings report.
" Given these specitications, it is possible to provide a relatively complete description of an equilibrium. I present results here only concerning equilibrium earnings management policies. Other results, along with some pertinent computations, may be obtained from the author.

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This example also illustrates what modifications must be made to the "reporting set" Yix,+,; 6,+,) to get alternative forms of income-smoothing behavior. For example, if we define:
it is easy to show, when the hypotheses of this example continue to hold, that the optimal earnings management policy y,+i () takes the form:
fx,+i + c,-n, if Xi+i + (,+i < y
= <y,
if X M I -

f,+i < y ^ x,+i + e,+,

e,+ i, i f X;+i - e,+ i > y .

When there are two-sided constraints on the manager's earnings reports, he overreports when realized earnings are low and underreports when realized earnings are high, consistent with conventional notions of income-smoothing.
4.4 INCOME-SMOOTHING AND CAPITAL MARKETS

The preceding analysis was conducted under the assumption that the manager had no access to capital markets. Although this is a conventional assumption in the multi-period agency literature, it is obviously not realistic. Since income-smoothing was shown to be a device to facilitate consumption-smoothing in the preceding section, one might suspect that if the manager is capable of borrowing and lending on his own account, then income-smoothing would no longer occur. The purpose of this subsection is to present an example which demonstrates that this conjecture is not correct. In this example, the manager's preferences for consumption and effort are posited to take the form:
, a/) + fiUic,+-2, a,+,) (2)

where: i, a,) = -exp[-r(c,+, The manager's utility function is time-separable with constant absolute risk-aversion and multiplicative (rather than additive) disutility from effort. The purpose of this specification of preferences is (1) to ensure that the manager's second-period effort choice is unaffected by any savings left over from his first period in office (the constant absolute risk-averse utility function assures the absence of such wealth effects) and (2) to make the manager's second-period individual rationality constraint "sensible" in the presence of borrowing and lending from previous periods. In the second period, the manager's willingness to accept the firm's contract should not be influenced by how much he has saved from the first period, but rather by the utility the contract itself provides. Thus, for example, if the manager saved $ V (with interest) for V

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consumption in period t + 2 and was offered the second-period contract s{x,.t-i}, it is inappropriate to write the second individual rationality constraint as: E[Uis(xn2) + W, a,+,)] > U. Instead, this constraint should be written:
i>,-j), a,.,d] ^ U,

r.])

even though the manager's total expected utility in period / + 2 is given by the left-hand side of (3). The negative exponential utility function makes feasible the decomposition of the manager's expected utility into that derived from his employment contract and that derived from his previous savings. (Unfortunately, most risk-averse utility functions do not have this property.) With these specifications, and assuming that the manager can borrow and lend any amount on the capital market at interest rate I) 1, we have the following result. PROPOSITION 5. (a) If the manager's preferences and second-period individual rationality constraint respectively take the forms given in (2) and (3) above, and assumptions (i) - (v) of Proposition 4 hold, then a necessary condition for the manager not to engage in income-smoothing when he has access to capital markets is that his compensation function be a linear function of earnings, whether or not {e,| is degenerate, ib) If, further, the manager's first-period consumption sometimes exceeds his first period's compensation, then the manager will engage in incomesmoothing whether or not his compensation function is linear. This result demonstrates that access to capital markets will not eliminate income-smoothing in general. The reason is that when the manager has access to both capital markets and income-smoothing to facilitate consumption-smoothing, he will typically use both to take advantage of any differences in their rates of return. Investing $1 in the capital market today will yield the manager $h tomorrow. If the manager were to income-smooth when his first period's earnings realization is x,+ i, he can reduce his consumption today by $1 and get back tomorrow the uncertain return s,+2ix,+-2 + co), where s,+i(x,+ ,) - .s,-n(x/-, i - w) = $1. For the manager never to seek to engage in income-srroothing when he has access to capital markets, the rate of return 3 must be identical to the rate of return s,^-,ixM2 + <^) (appropriately adjusted for the latter's increased riskiness) for every x,+ i; if the latter return were even greater (less) than 3, the manager would be inclined to save (borrow) more than he would if he only had access to capital markets. When the manager's compensation scheme is nonlinear, it is possible to show that there are always some profitable intertemporal transfers to engage in via incomesmoothing. When the manager's compensation scheme is linear in his periodic earnings report, the rate of return on income-smoothing is constant, just as the rate of return in the capital market is constant, and

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SO, in this linear case, it is possible that augmenting the manager's ability to transfer consumption intertemporally via income-smoothing may not increase his utility beyond that achievable by his participation in the capital market. But, even in this linear case, if we knew that the manager's first-period consumption sometimes exceeds his first period's compensation, we can conclude that the manager must income-smooth: the discount rate on income-smoothing is zero (a $1 reduction in compensation today is offset by a $1 increase in compensation tomorrow if the same linear compensation schedule is in effect both periods), whereas the discount rate in the capital market is positive. Hence, the manager will borrow via income-smoothing (transferring the firm's earningsand hence consumptionforward, when the compensation function is increasing) and save via the capital market.

5. Conclusions
This paper identifies two distinct sources of shareholders' demand for earnings management: an "internal" source, intended to minimize the expected cost of getting a manager to adopt shareholders' preferred action, and an "external" source, based on current shareholders' desire to influence prospective investors' perceptions of their firm's value. The existence of the internal source of earnings management was shown to vary systematically with the ability of managers to communicate all dimensions of their private information. In contrast, the existence of the external source of earnings management was shown to vary systematically with the ability of prospective investors to observe the contractual relationship between current shareholders and their management. In addition, both sources of earnings management are affected by the dependence of both the corporation's and the management's (personal) cost of earnings management on the manager's earnings announcements. In addition, the model of section 4 illustrates circumstances under which income-smoothing is sustainable as equilibrium behavior. Several economic forces which could impinge on income-smoothing have not been considered here. There is no labor market on which managers could develop reputations for not managing earnings, nor has consideration been given to explanations of earnings management based on the bounded rationality (see, e.g., Simon [1955]) of either current or prospective investors. Limits on the rationality of either group of investors could generate earnings management, of course. The analysis has been undertaken within the "mechanism design" paradigm (see, e.g., Hurwicz [1972]). In the present context, this implies that current and prospective owners rationally anticipate the earnings management induced by management compensation schemes and adjust their actions accordingly. Whether the "mechanism design" approach taken here is superior to this "bounded rationality" alternative remains an open ques-

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tion, since a formal, operational theory of the latter has yet to be developed. There are several earnings-related questions which this paper leaves unanswered. No explanation of large write-offs to earnings is provided, nor is the reluctance of firms to divulge all details of their manager's compensation rationalized. The latter phenomenon is particularly puzzling, because it can be shown in the context of this paper that there are strict welfare gains for current shareholders to disclose the details of management compensation arrangements. There must be powerful forces, such as the possible proprietary losses arising from compensationrelated disclosures, opposing these gains from disclosures, which are not modeled here. This paper also has not explored the relation between the interest rate investors use to discount a firm's cash flows and the firm's earnings management policy. Such an exploration would be helfpul in examining claims that investors employ a higher interest rate to discount the cash flows of firms whose time series of earnings are volatile." And no analysis of the earnings management policies adopted by very longlived managers (to reflect the typical case in which the tenure of managers exceeds the tenure of a typical stock in an investor's portfolio) has been undertaken. Extensions of the model developed in section 4 may he useful in improving empirical studies which attempt to document income-smoothing behavior. Conventional studies merely establish whether the time series of earnings exhibits certain statistical properties, such as negative autocorrelation (see, e.g., Ronen and Sadan [1981]). But such studies ignore the usefulness of market reactions to earnings announcements in obtaining estimates of the magnitude of earnings management. Models of income-smoothing may help create estimates of the market's assessment of the amount of earnings management as a function of the observed stock price reactions to earnings announcements. The time-series properties of these estimates (rather than total earnings) may then provide evidence about managers tendencies to smooth income. Finally, it should be noted that the "financial" overlapping generations model developed here may be useful for studying a variety of phenomena other than earnings management, such as determining the factors which contribute to managers' alleged emphasis on short-run performance, or evaluating the relative merits of alternative earnings measures. This overlapping generations framework is well suited for such studies, because it embeds the principal-agent contracting problem into a capital market setting.

'' See Trueman and Titman [fortbcoming] for an analysis of tbis effect.

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APPENDIX A Earnings Management Proof of Proposition 1

Observe, first, t h a t since c(x,, y,, e,) > 0 for all y, a n d c(Xf, Xt, (,) = 0: - c{x,, y, e,) ! v=r = 0. ^y

Consequently, if s ( ' ) is the contract offered to the manager, to obtain no earnings management, i.e.: X, E arg max ye s(y) c(xj, y, t,) (with probability one)

Y{x,,i,)

we would require that the following first-order condition be satisfied:

TT [s{y) - c(x, y, e,)] | :=.,, = 0. dy

But this implies:

,s(y)|,_,, = 0 dy

for every possible realization of X/. This can only happen if s(y) is a wage contract, which will fail to get any action other than a implemented. Proof of Proposition 2 (i) The proof for OCE is trivial: let a* attain Max\E[x | a] - w{a)\ and
11, A

define u hy v = {E[x | a*] ;(a*))/r. Set y(x, t) = x + ( and P{y) = E[x \a*, y = i + U + 1^/(1 + r). Given this specification of P{'), it is clear that a* is the "right" action for current shareholders to adopt, since they wish to choose a to maximize E[P{y{x, e)) | a] w(a). These remarks, in conjunction with {iib) below, which shows that the policy y(x, () = X -h ( is a cost-minimizing announcement policy regardless of what action a the manager is directed to take, complete the proof of (i). {ii) The proof for NCE runs as follows: if future investors believe current investors induce their manager to adopt the earnings announcement policy y(x, t) = x + t, then current investors will in fact adopt that announcement policy because: {iia) that policy maximizes the price of the firm for every realization (x, i) of (x, t), as E[x \ X + e = y, a] and therefore P{y) ^ E[x \x + i y, a] + v/il + r) is easily shown to be increasing in y for any realization {x, e) of (x, e) (no matter what action a t A future investors believe the

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manager adopted) andy(x, () = Sup Yix; t); iiib) that policy minimizes the expected cost of whatever action, say a* G A, current investors seek to have their manager adopt: this claim follows by observing that, given any contract s( ). there exists an increasing contract .s*(') which induces the manager to take the same action as he took under ,s(*) and generates the same expected costs to the current investors. (The contract s*iz) = Sup .s(y) does the job, since, for any ix. < V. .s*(x + t) = Sup siz) = Sup ,s(2) = siiyix, <)),
r C V (.V

where yi', ) is (defined to be) the manager's utility-maximizing announcement, given the original contracts(')- Observe that.s*(2) increases in 2, so yix, t) = x + f is the manager's utility-maximizing announcement policy, given ,s*(*)-) Combining (iia) and iiib), we see that the announcement policy which maximizes the expected value of the firm is the same as the announcement policy which minimizes the cost (to current investors) of getting the manager to adopt their preferred action. Thus, this is the policy which will be implemented. Now, to verify the existence of an equilibrium action a* E A, we appeal to two theorems from mathematics: (1) Berge's [1963] "maximum theorem": if f:S X T*Ri& a continuous function and T is compact, then the set (/)(x) of values y which attain Max fix, t) forms an upper-semicontinuous correspondence (in x). (2) Kakutani's fixed point theorem (see, e.g., Debreu [1959]): if S is a nonempty, compact, convex subset of IR'" and 0:6' -^ S is an uppersemicontinuous correspondence such that, for all x E 6\ <l)ix) is convex, then there exists a fixed point x* of <j), i.e., x* E ^(x*). To apply these theorems to our problem, let's assume that future investors believe current investors have enticed their manager to adopt some action aG A. Then, we know from above that the current investors will have their manager adopt the earnings management policy yix, () = X + <. Furthermore, if we let v denote the value of the firm exclusive of current-period earnings, it follows that current investors will want their manager to adopt an action a which solves: Max |J/|[x I i + f = y(x, f), a) + u/(l + r)\ fii j a)hi}) dx di - wU,)\. Here, wia) denotes the expected cost to current investor^ of getting action a G A implemented in a least costly way and hi') denotes the density of t. This program maximizes the firm's selling price net of the cost of compensating the manager. Our hypotheses guarantee that the

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maximand in this program is (jointly) continuous in (a, ), so we can apply Berge's theorem to conclude that its set of maximizers, r(a), is upper-semicontinuous. In fact, this set Tia) is convex: let h{y \ a) denote the density ofy = x+t, given a. h inherits the concavity of distribution function condition from x, so, since E[x\x + (= y, a] is increasing in y, the integral part of the maximand is concave in a for any fixed a. Since wia) is, by assumption, convex in , this implies that the (whole) maximand is concave in a for every o. Hence, the set of mazimizers Via) is convex, i.e., r(') is convex-valued. Since the agent's action set A is a closed interval, we can now apply Kakutani's theorem to establish the existence of a fixed point a* of r(-)- Notice that this fixed point does not vary with u, the hypothesized value of the firm to the next generation of shareholders (exclusive of current-period earnings). Hence, there is no circular reasoning involved in setting u = iE[x \ a*] - wia*))/r. With these specifications, the proof is complete. Proof of Proposition 3 Proof of 3.1. Let v/il + r) denote the present value of the firm to the next generation exclusive of next period's economic earnings. Conditional on the realization of x, this value is independent of any policies adopted by prior generations of investors or managers. If the next generation believes that the private (public) earnings management policy adopted by the prior period management is y(x, f) (y(x, ()), then the marketclearing price of the firm contingent upon the announcement of y is: E\x - lix, y(x, f), e) -I- t)/(l + r) I a, y = y(x, e)], where a is the action which the next generation of investors can infer from observation of the management's contract. Investors of the prior generation seek to maximize:
E[E[x -lix, y(x, f), 6) + v/il 4- r) I a, y = yji, i)]

subject to: ii) for all (x, (), y(x, t) E arg max siy) c{x, y, e) Hi) oG arg max E[Uis{yix, ()) - cix, yix, 0, 0 I d] iiii) E[Uisiyii, e)) - c(x, y(x, I), i)) \ a] - gia) > U iiv) for all (x, e), y(x, e) E Yix, t). (Since y(x, () does not enter into the manager's contract, he will adopt any earnings announcement policy which the investors who hired him prefer, subject to the public informational constraints iiv).) Since the unconditional expectation of a conditional expectation is the

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RONALD A. DYE

unconditional expectation (see, e.g., Chung [1974, p. 304]), it is clear thai the expected proceeds investors receive from the sale of the firm are independent of the public disclosure policy y, i.e., the objective function (A3.1) equals: E[x ~ l{x, yix, f), t) - s(y{x, I)) + v/H -I- r) | a]. Therefore, contingent on seeking the manager to select a particular action a, investors obtain no benefit from implementing any contract or announcement policy which does not minimize:
E[l(x, yii, (), f) -h siyix, t)) | a],

subject to constraints {i)-iiii) above. This completes the proof of Proposition 3.1. Proof of Proposition 3.2. Using the notation of the previous proof, we note that investors wish to maximize:
E[x - / ( i , ^ ( x , (), I) ~ s(y_{i, t ) ) + v/{l + r) \a\ (A3.2)

subject to: (0 for all (x, e), y(x, e) E arg max s(y) c(x, y, t)
(ii) a G a r g m a x E[U{s{y{x,
(ie/i

e ) ) - c ( i , y{x, t ) , i)\a\y_(i, . ) , e)) | al - g(a) > U t).

gia)

iiU) E[U{s{y^{k,

D) - di,

{iv) for all (x, t), y_{x, t) e Y(x,

(The representation of the objective function (A3.2) also relies on the fact that the unconditional expectation of a conditional expectation equals the unconditional expectation.) It is clear that, holding>(x, t) and a fixed, the objective function is maximized by choosing ^(x, <) to minimize:
E{lix, y{x, t ) , f) I x]

subject to (it;). Since x G Y{x, t) and l{x, x, t) ^ 0, it is clear that y{x, e) = X is optimal (uniquely optimal if l{x, y, t) ?^ 0 for y ?^ x). To show that there are benefits to having separate public and private earnings announcements simply involves finding circumstances under which y{x, t) ^ x is not optimal. But, under the hypotheses of Proposition 1 above, the policy y(x, e) ^ x is not even feasible. This completes the proof. Proof of Proposition 3.3. Observe that for any NCE in which the public earnings announcement .y does not affect c or /, current-period investors will instruct their manager to choose that public announcement y which attains: Max P{y).

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Since Pi') is strictly increasing by hypothesis, ^(x, e) = x + tis uniquely optimal. Also observe that, conditional on current investors' decision to have their manager choose some action a, they will pick that contract s(") and private earnings announcement policy yi *) which minimizes E[s{y{x, t)) j a] and not: E[siyix, e)) + lix, yix, i), e) | a],

sincein an NCEnext period's investors cannot observe the current manager's contract, and hence will not pay more for the firm if the current investors reduce current management's incentives to incur corporate costs of earnings management (contrast this to what happens in an OCE). Since C2ix, x + e, e) ^ <x>, yix, f) = x -I- e is not the costminimizing means of implementing any action, so y 9^ y. Proof of Proposition 4 The proofpresented here involves the study of x,+ , ^2,+, (so/(x,+ i | a,) is the same as qizt+\ |a,) when x,+ i = 2, + i). The proof of the general case is available from the author. Let t be a particular even-numbered period. Recall that investors born in period t receive the sum of period t's actual earnings plus any undistributed earnings of period t 1. Also recall that the period t earnings announcement yi is constrained by y, :< x,-, + x, - y,-i. Putting aside incentive problems momentarily, it is clear, holding the manager's period t 1 action and earnings announcement policy fixed, that the period t market-clearing price of the firm is maximized only by having the manager adopt the period t earnings announcement policy:
y,*(x,-.,, X,, e,-i) ^ x,_i + X, y,..i;

any other policy necessarily reduces the perceptions of investors born in period t regarding the firm's total earnings. It is easy to show (as in the proof of Proposition 2) that the manager's period t contract Stiyt) can be replaced by another contract .s-,*(y,) which is nondecreasing in y, and which gives the manager the same compensation (and hence generates the same cost for investors) in all states as s,. Clearly, y,* is an optimal reporting strategy for the manager to adopt when compensated with .s,*. Therefore, since s* incurs the same cost to investors as s,, induces the manager to take the same action(s) as St, and gives the manager an incentive to adopt the unique period t valuemaximizing earnings announcement policy y,*, the earnings announcement policy yi associated with this equilibrium must equal (identically) y*. Otherwise, s* and y,* could be implemented, and investors of gener-

232

RONALD A. DYE

ation t 1 would be strictly better off, contrary to the definition of an equilibrium. Thus, y,*(*) must be the manager's period t earnings announcement policy. Therefore, in order for income-smoothing not to occur, no earnings management can take place in period i 1. To see this, simply note that if y,_.i(x,-i, (, i) < x,. , occurs with positive probability, then y,*(x,-,, Xl, (,_|) > X, occurs with positive probability also (similar remarks also apply with both inequalities reversed). But, if no earnings management occurs in period ^ 1, then there are (by definition) no undistributed earnings in period t\. Therefore, since the density/(x, | a,-i) is the same as the density/(x,-, | a,-,) if o,.,. = a,-i, the optimal contract investors of generation t 1 offer the manager will be exactly the same as the optimal contract investors of generation t 2 offered the manager (remember, all contracts between the manager and investors are one-period contracts; if there are no undistributed earnings in period t 1, investors of generation I 1 face exactly the same production conditions as do investors of generation t ~ 2: by this symmetry, the optimal contracts they offer must be identical). Let this common contract be denoted by s{y). Now consider the manager's problem at the end of period t 1 when actual economic earnings equal x,-, and f,-i equals t, \. For incomesmoothing not to be desirable, there must be no W ox aE. A with W < e,_] such that: a(s(x,-,, - W)) + n\E[U{s{i,^ W))\a\ - g{a)\ exceeds: U{s{x,-.\)) -I- nMay.{E[U{s{x,)) \ d] - g{a)].

In particular, if o* attains Max \E[U{s{xi)) \ a] g{a)\, we must not have the derivative of (A4.1) with respect to W evaluated at W = 0 and a = a* be positive. This derivative, however, equals: -f/'(.s(x,_,)).s'(x,_O + i.,E[U'{s{i,))s'{i,) I a*\. (A4.2)

Obviously, if ^ = 1, there exists a set of x^-.'s of positive probability such that (A4.2) is positive, unless s{*) is constant. (Notice that this is true even iff, i is identically zero.) But constant contracts cannot be optimal by the second hypothesis of the proposition. Therefore, the assumption that no income-smoothing occurs leads to a contradiction, when the manager does not discount future consumption. A similar contradiction is obtained whenever ii is sufficiently near one. This completes the proof of the iid case.

Proof of Proposition 5
We know, from Proposition 4's proof, that income-smoothing occurs over the periods 1+^,1 + 2 unless earnings management does not occur

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in t + I. If earnings management does not occur in t + 1, then y,+, = x,+ i and y,+2 = Xi,2. Let s, + ,i') and a, he the manager's firstperiod contract and action, let x,+ , = x,+ , occur, and let the manager believe, correctly, that his second-period contract is St^-zi'), and that his optimal second-period action, given this contract, is a,+i. If the manager were to report the truth (y,+ i = x,+ i) and save L(x,+,) for consumption in t + 2, his expected utility would equal:

The optimal choice of L(x,-n) is determined by the first-order condition:

If, taking this borrowing/lending behavior as given, the manager were to understate actual period f + 1 earnings by w, his utility would be:

For the manager to have no incentive to engage in income-smoothing, a? = 0 must maximize the preceding expression for almost every x,+\. Hence, the first-order condition for the optimal a? must be satisfied by a; = 0, i.e.:

dx,-

Observe that if we multiply the LHS of (A5.1) by sU.ix,,^) we get the LHS of (A5.2). Hence, a necessary condition for no income-smoothing to occur is that the RHS of (A5.1) multiplied by s;+,(x,+,) equal the RH8 of (A5.2), or equivalently, after dividing out common terms to both expressions:

J J

dx,,-,.

(A5.2)

We now argue that, given the special form of the utility function and second-period IR constraint, the manager's optimal second-period contract and action do not vary with x,-^. To see this, simply note that the manager's second-period expected utility can be written in the form:

(A5.3)

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RONALD A. DYE

The multiplicative term: is clearly irrelevant to the manager's action choice and, by the special way the second-period IR constraint is written, to the IR constraint too. This proves the claim. With this result, it follows from (A5.3) thats;+i(x,+ i) must be the same for all x,+ i, i.e., ,s',+i must be linear. Now apply the argument used in the proof of Proposition 4 to conclude that if the manager does not engage in income-smoothing, then he will be given the same contract (and hence be encouraged to take the same action) in both periods he is in office. Hence, the manager will be given the same linear contract in each period. This implies that the discount rate at which the manager can shift consumption across periods by income-smoothing is zero for all realizations of x,+ i. The rest of Proposition 5 then follows immediately from the hypothesis that the manager is assumed sometimes to borrow in his first period in office, because the discount rate applicable in the capital market is positive (and he would never borrow at that rate, given access to a zero-interest-rate loan).
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paper, MEDS, 1987. GREEN, E. "On the Difficulty of Eliciting Summary Information," Journal (if Economic Theory 32 (1984): 228-34. GREEN, J., AND J. LAFFONT. "Partially Verifiable Information and Mechanism Design." Working paper. Harvard University, 1983. GROSSMAN, S., AND O. HART. "An Analy.'^is of the Principal Agent Problem." Econometrica (January 1983): 7-46. HARRIS, M., AND R. TOWNSEND. "Resource Allocation Under Asymmetric Information." Ecunometrica (January 1981): 33-64. HOLMSTROM, B. "On Incentives and Control in Organizations." Ph.D. dissertation, Stanford University, 1978. HuRWlcz, L. "On Informationally Decentralized Systems." In Decision and Orgamzation, edited by S. McGuire and R. Radne. Amsterdam: New Holland, 1972. KARAKEN, J., AND N . WALLACE. ModeLs of Monetary Economics. Minneapolis: Federal Reserve Bank of Minneapolis, 1980. KATZ, M. "Game-Playing Agents: Contracts as Precommitments." Working paper. Prince ton University, 1987. LAMBERT, R. "Long-Term Contracts and Moral Hazard." Hell Journal (if Kconomics (Autumn 1983): 441-52.

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