Enforcement of Optimal Disclosure Rules in the Presence of Moral Hazard

Abstract

This paper analyzes the role of disclosure enforcement mechanisms (such as SEC enforcement teams and corporate governance systems) in directing the disclosure practices of managers when the information is used by shareholders to monitor the manager. The paper establishes a role for a disclosure enforcement system by showing that in its absence it is impossible to simultaneously induce a manager to adopt the desirable disclosure strategy and use the disclosure efficiently to monitor him. The paper shows how the effectiveness of the disclosure enforcement system and the cost of disclosure influence (i) the economic viability of the disclosure enforcement system, (ii) the disclosure policy of the manager, and (iii) the value of including stock options in the manager’s compensation package.

Keywords: accounting, disclosure enforcement, concealment cost, moral hazard, optimal compensation, stock options

JEL Classification: D82, D86, G34, M41, M48