Executive compensation and earnings management under moral hazard

This paper analyzes executive compensation in a setting where managers may take a costly action to manipulate corporate performance, and whether managers do so is stochastic. We show that an increase in the possibility of manipulation actually calls for executive pay to be more responsive to reported performance. In addition, regulatory reforms that increase the cost involved in manipulation may lead to reduced pay-for-performance sensitivities. The time-series and cross-sectional variations of executive compensation lend support to our model.