Managerial Incentives, Fraud, and Monitoring

Equity-based compensation, while inducing greater managerial effort, also provides incentives for managers to fraudulently inflate a firm's stock price. This paper examines the owners' optimal contract in the face of these conflicting incentives when it is sometimes possible for the manager to commit fraud and the public disclosure of fraud harms the underlying value of the firm. The analysis shows that an increase in the likelihood of fraud can actually increase the attractiveness of equity compensation and the value of the firm. Ironically, while monitoring decreases the likelihood of fraud, it may indirectly increase the severity of fraud when fraud occurs