Optimal Managerial Compensation, Earnings Manipulation, and Manager Ownership by

The optimal management contract is derived in an environment in which a manager can influence the distribution of earnings through an unobservable effort decision, only the manager observes actual earnings, and the manager can engage in costly reported earnings manipulation. The manager's compensation is required to satisfy an ex ante participation constraint that reflects the cost of effort and an interim participation constraint that guarantees the manager nonnegative rent (gross of ex ante effort costs) conditional on the manager having observed the firm's actual earnings. The optimal contract is shown to have several features: a manager who observes earnings in a range at the bottom of the distribution will earn zero rent (gross of the cost of effort), a manager who observes earnings above this range will earn positive gross rents, and both underand over-reporting is induced with over-reporting always corresponding to high earnings. We then study how endowing the manager with shares in the firm affects both the optimal contract and the expected profit of the owner. A general condition is derived that determines when giving the manager additional shares in the firm increases expected owner profit. We find that the optimal managerial compensation contract will contain both stock options which may be repriced after earnings are reported, as well as bonuses paid on the current (and manipulated) reported firm earnings.