Lying to Speak the Truth: Selective Manipulation and Improved Information Transmission

Abstract

We analyze a principal-agent model in which an effort-averse agent can manipulate a publicly observable performance report. The principal cannot observe the agent's cost of effort, her effort choice, and whether she manipulated the report. An optimal contract links compensation to the eventually realized output and, in certain situations, to the (possibly manipulated) report. We show that the optimal contract may incentivize selective manipulation of an unfavorable report by an agent who exerted a high level of effort. Doing so can convert a "falsely" negative report into a positive one, thereby making the report more informative about the agent's effort choice.

Keywords: Adverse Selection, Moral Hazard, Performance Manipulation, Earnings Management, Corporate Governance, Executive Compensation

JEL Classification: D82, D86, G34, M12, M41