Earning Management and Agency Theory: Smoothing vs. Manipulation

This essay provides a comprehensive overview of agency theory, focusing on the relationship between principals and agents, information asymmetry, and moral hazard. It explores positive accounting theory and the economic consequences of accounting choices, including earning management and income smoothing. The discussion extends to the role of earning forecasts and the impact of management strategies on company performance. The document provides valuable insights into the complexities of agency theory within financial and economic contexts. Desklib offers similar solved assignments and study resources for students.

Running Head: AGENCY THEORY
AGENCY THEORY
NAME OF THE STUDENT
NAME OF THE UNIVERSITY
AUTHOR NOTE

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Table of Contents
Answer to the question 1............................................................................................................2
Answer to the question 2............................................................................................................2
Answer to the question 3............................................................................................................3
Answer to the question 4............................................................................................................3
Answer to the question 5............................................................................................................4
References..................................................................................................................................6

2Agency Theory
Answer to the question 1
The principal to solve the issues between the principles of the business and the agents
are generally termed as the Agency Theory. This relationship lies between the agents or the
company executives and the shareholders or the principles. In this type of relationship there is
a delegation of the decision-making authority to the agents by the principals. This is due to
the fact that the decisions of the agents generally affect the principal financially and therefore
there might arise the priority and interests differences. This kind of problems is generally
termed as the principal-agent problem (Chari 2019).
The examples that might relate to the information asymmetry is when there is the
deal, where the entrepreneurs and the private equity shareholders have a difference in opinion
and they think they have better information than the other person. This kind of post deal
problems generally contribute to the moral hazard which create problems for the capitalist
and the equity operators where they do not know how the entrepreneurs will react to the
financial information that has been provided (Cuervo‐Cazurra, Mudambi, & Pedersen, 2019).
Answer to the question 2
Research in the fields of economic lead to the birth of the term called a positive
accounting theory. This is the theory which explains what accounting is truly is and why is
the way it is and it also defines the result that the figures have on the resources that to be
allocated and on the people. The critical review and the research has been conducted which
has been primarily determined by the agency theory. This has been particularly made with the
aim to highlight the determinants of the decision taken that is taken by the shareholders of the
company which is authorized by the standards that authorizes the shareholders to take such
decision while formulating of the policies. In the term agency theory the company is said to

3Agency Theory
be in the center of the contracts and include all informal and formal and which is
communicated between the director and the stockholders. The accounting part produces the
information that proves to be the information that are needed to control the execution of all
this contracts. It has been noted that the positive accounting states the decision made for the
choices the directors has made for the accounting method with reference and keeping in mind
different financial and economic characteristics of the company which includes checking
their debt, its size as well as the stock exchange listings ( Mitnick,2019).
Answer to the question 3
Studies related to the economic consequences that are as a result of the accounting
choices have developed several economic factors which explained different sort of actions
that it has over the firms. Some factors are taxes, political cost and ownership controls and so
on. The study suggested that these factors will motivate the firm to maximize or minimize the
reported earnings by making certain accounting choices and therefore it shows the
dependence of the level of earnings and the accounting choices. However, the income
smoothing states the fact that the accounting choices are needed to reduce the earnings rather
than minimizing and maximizing the reported earnings ( Osma, Mora, & Porcuna-Enguix,
2019) The study has further found the evidences that the smoothing will be dependent on the
firm size, the existence of the bonus structure and incentive structure and also it depend on
the divergence of the expectations and the actual earnings.
Answer to the question 4
Earnings are the profit of the company. In the stock market, the companies with the
poor earning share will have a lower share prices as compared to the company with higher
income prospect. Therefore earning management is basically a strategy that are utilized by
the management in order to manipulate the earnings of the company so that the company

4Agency Theory
reach the target level that is pre-determined. It has been noted that there has been different
methods that has been used by the managers to smooth earnings can seem to be very
confusing. However, it also has to be noted that the driving forces that are behind the
management of earnings are the requirement to meet the pre-determined target (Pappas et
al,2019) However the abusive earning management are something where the Securities and
Exchange Commission deemed to represent it as the material and intentionally
misrepresentation of the results. When there is excessive smoothing then the SEC imposes
the fine (Irawati, Marlina,& Sipayung,2019). Whole of the agency theory area works in the
earning management, however, income smoothing even out the income along with the
intention of showing lesser risks to induce less volatility.
Answer to the question 5
Earning forecast are generally based on the expectation of the company growth and
the profitability as per the analyst of the company. In order to predict the earnings the analyst
generally build financial models in order to estimate the prospective revenues and the costs.
The other factors that are considered by the analyst are the macro-economic factors and
economic growth rates and the currency rates which will influence the growth of the
corporate. The analyst make use of the market research in order to sense the trend which is
going on. In order to predict the revenue the analysts estimates the sales volume growth and
also estimate the charges that the other company are charging over their products. Forecasting
by the analyst is one of the most critical work since it contribute to the valuation of investor’s
model (Nuryana, & Surjandari, 2019). Therefore, forecasting is relevant irrespective of the
fact that they might have lesser earnings than the forecasted one. This is due to the fact that
the divergence may arise due to several reasons, which will be avoided and be taken care of
in the next forecast. However, forecasting is essential step and earning management has to be

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continued as it will not only maximize the earning rather it also focusses on the minimization
of the costs.

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References
Chari, M. D., David, P., Duru, A., & Zhao, Y. (2019). Bowman's risk-return paradox: An
agency theory perspective. Journal of Business Research, 95, 357-375.
Cuervo‐Cazurra, A., Mudambi, R., & Pedersen, T. (2019). Subsidiary power: Loaned or
owned? The lenses of agency theory and resource dependence theory. Global Strategy
Journal, 9(4), 491-501.
Cuervo‐Cazurra, A., Mudambi, R., & Pedersen, T. (2019). Subsidiary power: Loaned or
owned? The lenses of agency theory and resource dependence theory. Global Strategy
Journal, 9(4), 491-501.
Irawati, N., Marlina, L., & Sipayung, F. (2019, October). Analysis of the impact of Leverage,
Value Added and Size on Earning Management and Financial Performance of Indonesian
Shariah Banking. In 2019 International Conference on Organizational Innovation (ICOI 19).
Atlantis Press.
Mitnick, B. M. (2019). Origin of the theory of agency: an account by one of the theory's
originators. Available at SSRN 1020378.
Nuryana, Y., & Surjandari, D. A. (2019). The Effect of Good Corporate Governance
Mechanism, and Earning Management on Company Financial Performance. Global Journal
of Management and Business Research.
Osma, B. G., Mora, A., & Porcuna-Enguix, L. (2019). Prudential supervisors’ independence
and income smoothing in European banks. Journal of Banking & Finance, 102, 156-176.
Pappas, K., Walker, M., Xu, L. A., & Zeng, C. (2019). Do Government Subsidies Affect
Income Smoothing?.