Optimal Contracts with Performance Manipulation
Stanford University - Graduate School of Business
New York University (NYU) - Leonard N. Stern School of Business; New York University - Stern Scholl of business
Stanford Graduate School of Business
June 4, 2014
Journal of Accounting Research, Forthcoming
Rock Center for Corporate Governance at Stanford University Working Paper No. 152
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.
Number of Pages in PDF File: 41
Keywords: Compensation, Governance, Moral Hazard, Earnings Management
Date posted: April 17, 2012 ; Last revised: June 18, 2014