Contract Disclosure, Earnings Management, and External Enforcement
50 Pages Posted: 30 Jan 2020
Date Written: January 6, 2020
We examine the effects of mandating compensation disclosure on executive incentive contracts, earnings management, and shareholders' and social welfare. We develop a moral hazard model with multiple principal-agent pairs facing an external inspector who allocates resources across firms to uncover and penalize earnings management. Contract disclosure confers principals with a first-mover advantage, allowing them to design the contract anticipating the inspector's reaction. However, it may also exacerbate a coordination problem among principals, as they do not consider externalities on other principals caused by the effects of their contract choices on the inspector's scrutiny allocation. We find that, if the internal enforcement intensity (e.g., internal control) is relatively weak, contract disclosure may make contracts more strongly contingent on reported earnings, worsen earnings manipulation, and nevertheless increase social welfare. However, disclosure improves shareholders' welfare only if the scrutiny resources available to the inspector are not strongly constrained.
Keywords: Compensation; Contract Disclosure; Coordination; Enforcement; Inspector
JEL Classification: C72, D62, G38, M43, M46
Suggested Citation: Suggested Citation