SEMINAR 13 September 2012: Thomas A. Gresik, University of Notre Dame

Optimal Compensation with Earnings Manipulation: Managerial Ownership and Retention

Abstract

The optimal managerial compensation contract is cha­racterized in an environment in which the manager influences the distribution of earnings through an unobservable effort decision. Actual earnings, when realized, are private infor­mation observed only by the manager, who may engage in the costly manipulation of earnings reports. We derive the optimal contract that guarantees the manager non-negative profit for any earnings realization (interim individual rationality) to ensure manager retention. We find that the optimal contract induces under-reporting for low earnings and over-reporting for high earnings, and that the optimal contract may be implemented through a compensation package composed of a performance bonus based upon (manipulated) earnings and a stock option that is repriced to be strictly in the money for intermediate earnings realizations and exactly in the money for low earnings realizations.