MANAGERS' COMPENSATION AND MISREPORTING: A COSTLY STATE VERIFICATION APPROACH

"We look for the optimal shareholder-manager contract leading to high effort and truthful revelation of firm performance. This twofold incentive compatibility constraint calls for a convex compensation scheme (a fixed wage plus a stock option) coupled with a state contingent audit. In order to reduce expected verification costs, an optimal stock option plan assigns the manager a large number of options with high strike price. It is suggested that focusing the audit activity (and supervision) on the exercise of stock option packages is a better solution to the problem of misreporting than giving up stock options as a compensation tool. "("JEL "D82, G30, M40, M52) Copyright (c) 2008 Western Economic Association International.