Optimal Compensation with Earnings Manipulation: Managerial Ownership and Retention

The optimal managerial compensation contract is characterized in an environment in which the manager influences the distribution of earnings through an unobservable effort decision. Actual earnings, when realized, are private information observed only by the manager, who may engage in the costly manipulation of earnings reports. We derive the optimal contract that guarantees the manager non-negative profit for any earnings realization (interim individual rationality) to ensure manager retention. We find that the optimal contract induces under-reporting for low earnings and over-reporting for high earnings, and that the optimal contract may be implemented through a compensation package composed of a performance bonus based upon (manipulated) earnings and a stock option that is repriced to be strictly in the money for intermediate earnings realizations and at the money for low earnings realizations.