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

Abstract

We show that firms may benefit from allowing some earnings management, because it can make noisy signals more informative. We model a firm that cannot observe a manager's cost of effort, her effort choice, and whether she manipulated a publicly observable signal. An optimal contract links compensation to both the eventually realized firm value and the (possibly manipulated) signal, since both are noisy measures of effort provision. It may be optimal to allow for manipulation of the signal by a manager who exerted a high effort level: Doing so can convert a falsely unfavorable signal into a favorable signal, thereby strengthening the link between effort and compensation.

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

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