Executive Compensation and Earnings Management under Moral Hazard

The paper investigates the optimal structure of executive compensation with the possibility of financial data manipulation. We characterize the optimal compensation contract analytically, and establish necessary and sufficient conditions for earnings management to occur. The model shows that the optimal pay-performance sensitivity increases with the possibility of manipulation, and thus provides an explanation for the positive association between earnings management and incentive compensation observed in both time series and cross section. In addition, the model's predictions regarding the changes of earnings management behavior and executive compensation structure in response to corporate governance legislations are consistent with empirical observations