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Optimal Contracts with Performance Manipulation

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

Anne Beyer

Stanford University - Graduate School of Business

Ilan Guttman

New York University (NYU) - Leonard N. Stern School of Business; New York University - Stern Scholl of business

Ivan Marinovic

Stanford Graduate School of Business

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)

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

44 West 4th Street
New York, NY NY 10012
United States

New York University - Stern Scholl of business ( email )

No Address Available

Ivan Marinovic

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

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