An Equilibrium Model of Incentive Contracts in the Presence of Information Manipulation

This paper develops an agency model in which stock-based compensation is a double-edged sword, inducing managers to exert productive effort but also inducing managers to divert valuable firm resources to misrepresent performance. We examine how the potential for manipulation affects the equilibrium level of pay-for-performance sensitivity and derive several new cross sectional implications that are consistent with recent empirical studies. In addition, we analyze the impact of recent regulatory changes contained in the Sarbanes-Oxley Act of 2002 and show that in some cases policies intended to increase firm value by reducing misrepresentation may actually reduce firm value or increase the upward bias in manipulated disclosures