An Equilibrium Model of Incentive Contracts in the Presence of Information Manipulation
Indiana University - Kelley School of Business - Department of Finance
Steve L. Slezak
University of Cincinnati - Department of Finance - Real Estate
Journal of Financial Economics (JFE), Forthcoming
EFA 2004 Maastricht Meetings Paper No. 3206
This paper develops an agency model in which stock-based compensation is a double-edged sword, inducing managers to exert productive effort but also inducing managers to divert valuable firm resources to misrepresent performance. We examine how the potential for manipulation affects the equilibrium level of pay-for-performance sensitivity and derive several new cross sectional implications that are consistent with recent empirical studies. In addition, we analyze the impact of recent regulatory changes contained in the Sarbanes-Oxley Act of 2002 and show that in some cases policies intended to increase firm value by reducing misrepresentation may actually reduce firm value or increase the upward bias in manipulated disclosures.
Keywords: Fraud, earnings manipulation, optimal contract
JEL Classification: D82, G34, J33, K22, M41, M43Accepted Paper Series
Date posted: March 30, 2006
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