Equilibrium Earnings Management and Managerial Compensation in a Multiperiod Agency Setting

To investigate how the possibility of earnings manipulation affects managerial compensation contracts, we study a two period agency setting in which a firm’s manager can engage in “window dressing” activities to manipulate reported accounting earnings. Earnings manipulation boosts the reported earnings in one period at the expense of the reported earnings in the other period. We show that the pay-performance sensitivities across periods must converge as the manager’s personal cost of earnings manipulation declines. We also find that the optimal pay-performance sensitivity may increase and expected managerial compensation may decrease as the manager’s cost of earnings management decreases. When the manager is privately informed about the payoff of an investment project to the firm, we identify plausible conditions under which prohibiting earnings management can result in a less efficient investment decision for the firm and more rents for the manager.