Managerial compensation as a double-edged sword: Optimal incentives under misreporting

Abstract

A well-known prescription in corporate governance is that high-powered incentive contracts such as performance bonuses are an optimal mechanism for aligning managers with shareholders on an efficient investment policy. However, if managers are able to manipulate profits in order to obtain the bonuses, such contracts become a double-edged sword. An agency model is proposed to analyze how compensation plans should be designed to counteract these perverse incentives while preserving the primary managerial incentives to select optimal investment projects. Implications of the results for real-world executive incentive plans are discussed and an analysis is conducted of regulatory policies such as penalties and bonus caps.