Optimal Contracts with Performance Manipulation

41 Pages Posted: 17 Apr 2012 Last revised: 18 Jun 2014

See all articles by Anne Beyer

Anne Beyer

Stanford University - Graduate School of Business

Ilan Guttman

Leonard N. Stern School of Business, New York University; New York University - Stern Scholl of business

Ivan Marinovic

Graduate School of Business, Stanford University

Date Written: June 4, 2014

Abstract

We study optimal compensation contracts that (i) are designed to address a joint moral hazard and adverse selection problem and that (ii) are based on performance measures which may be manipulated by the agent at a cost. In the model, 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 reported earnings, which can be manipulated by the manager.

Our model predicts that (i) the optimal compensation contract is convex in reported earnings;(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.

Keywords: Compensation, Governance, Moral Hazard, Earnings Management

Suggested Citation

Beyer, Anne and Guttman, Ilan and Marinovic, Ivan, Optimal Contracts with Performance Manipulation (June 4, 2014). Journal of Accounting Research, Forthcoming, Rock Center for Corporate Governance at Stanford University Working Paper No. 152, Available at SSRN: https://ssrn.com/abstract=2040986 or http://dx.doi.org/10.2139/ssrn.2040986

Anne Beyer

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Ilan Guttman (Contact Author)

Leonard N. Stern School of Business, New York University ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

New York University - Stern Scholl of business ( email )

Ivan Marinovic

Graduate School of Business, Stanford University ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

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