Optimal Contracts with Performance Manipulation


  • Accepted by Haresh Sapra. We thank David Aboody, Baricz Arpad, Suren Basov, Jack Hughes, Madhav Rajan, Stefan Reichelstein, Richard Saouma, Ilya Segal, Robert Wilson, and two anonymous referees for detailed feedback, and workshop participants at UCLA and Stanford University for many helpful comments.


We study optimal compensation contracts that (1) are designed to address a joint moral hazard and adverse selection problem and that (2) are based on performance measures, which may be manipulated by the agent at a cost. In the model, a manager is privately informed about his productivity prior to being hired by a firm. In order to incentivize the manager to exert productive effort, the firm designs a compensation contract that is based on reported earnings, which can be manipulated by the manager. Our model predicts that (1) the optimal compensation contract is convex in reported earnings; (2) the optimal contract is less sensitive to reported earnings than it would be absent the manager's ability to manipulate earnings; and (3) higher costs of manipulating reported earnings (e.g., due to higher governance quality) are associated with higher firm value, lower expected level of earnings management, and higher output.