Optimal Contracts with Performance Manipulation

Abstract:     
We study compensation contracts that are (i) designed to address a joint moral hazard and adverse selection problem and that (ii) must be based on performance measures which may be manipulated by the agent. A manager is privately informed about his productivity prior to being hired by a firm. In order to incentivize the manager to exert productive effort, the firm designs a compensation contract that is based on earnings, which can be manipulated by the manager.

Our model predicts that (i) the optimal compensation contract is convex in reported earnings and increasingly so when manipulating earnings is less costly; (ii) the optimal contract is less sensitive to reported earnings than it would be absent the manager's ability to manipulate earnings; and (iii) higher costs of manipulating reported earnings (e.g., due to higher governance quality) are associated with higher firm value, lower expected level of earnings management and higher output.

We study an extension of the model in which the information asymmetry between the manager and the firm is not only with respect to the manager's productivity but also with respect to his cost of manipulating reported earnings. We believe that our model may provide the opportunity to structurally estimate governance quality and to identify the extent of earnings manipulation from the shape of compensation contracts.

Number of Pages in PDF File: 40

working papers series