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 realized output and the (possibly manipulated) report. Manipulation can be beneficial to the principal because it can make the report more informative about the agent's effort choice, thereby reducing the agent's information rent. This is achieved through a contract that incentivizes the agent to selectively engage in manipulation based on her effort choice.

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

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