Effort and Honesty: Compensation Contracts in the Presence of Earnings Manipulation

Abstract

Compensating managers with incentive pay may motivate earnings manipulation. In this thesis, we develop models that suggest more efficient compensation con- tracts that incentivize managers to exert effort and report honestly. We analyze the manager's incentive to manipulate the financial statement when the manager is remunerated with short-term and long-term incentive pay and when we apply different performance measures in the manager's compensation plan. We find that short-term incentives motivates both effort and manipulation, while long-term incentives induces effort, but not manipulation. Shifting incentives towards relatively more long-term pay will reduce earnings manipulation while maintaining incentives for effort. This is because it is not possible to in ate long- term compensation through opportunistically overstating accruals. We also consider the manager's incentive to manipulate when the manager faces incentive plans with different performance measures. We predict that there will be less manipulation when the stock price is used as a performance measure relative to when accounting earnings is used. The reason is that when the reported earnings goes through the "filter" of the market participants, the value of a high earnings report is discounted if the market believes that the report may be ma- nipulated. This reduces the manager's benefit of manipulation. The consequence is less manipulation when the stock price serves as the performance measure.