Incomplete Contracts And Earnings Management

Based on the incomplete-contract theory, this paper reconstructs a framework of contract-enforcement by extending'self-enforcing scope'and re-explaining'vertical integration'theories. The integration relations among accounting law, accounting technology norms and accountants'sincerity are discussed on the basis of dual values of accounting institutions as public contracts. Then contract-enforcement theory of accounting is raised. Furthermore, the author applies the contract-enforcement theory into accounting to discuss the nature of earnings management(EM), why earnings management exists and its essence. The following arguments are then developed. Firstly, the accounting information after EM is still true. Secondly, the reason why earning management exists is that self-enforcing scope of individual transactor is smaller than expected on the market, i.e. the lack of trust performing of individual transactor in case there exist some public domains of accounting technology norms as public contract. Thirdly, earnings management is actually a kind of rent-seeking game among managers, CPA firms and controlling shareholders et al.. Then, this paper provides some empirical evidences of EM based on rent-seeking argument from perspectives of client importance and audit tenure. Finally, this paper puts forward some proposals to restraining earnings management.The main innovations of this paper are presented as follows. Firstly, by extending'self-enforcing scope'and re-explaining'vertical integration', this paper sets up a framework of contract-enforcement and applies it into accounting. Secondly, the author regards accounting system as a dual-value system which aims at both social justness and individual firm's operation efficiency. Thirdly, by decomposing accounting standards and accounting events, this paper innovatively develops an allocation pattern of accounting standards for accounting events and analyzes the nature and causes of EM. Forth, based on the contract-enforcement theory and game theory, the author analyzes the rent-seeking essence for EM. Finally, in the empirical section, the author discovers an interesting phenomenon that auditors can constraint earnings-decreasing EM, but cannot constraint earnings-increasing EM, which is different from previous findings.