Abstract
We consider an optimal contract between an entrepreneur and an investor, where the entrepreneur is subject to a double moral hazard problem (one being the choice of production effort and the other being earnings manipulation). Since the entrepreneur cannot completely capture the results of his effort, investment is below the optimal level and production effort is socially inefficient. The opportunity to manipulate earnings protects the entrepreneur against the risk of a low payoff when the results of production are low. Ex-ante, this provides an incentive for the entrepreneur to increase investment and improve effort. Based on this insight we make several empirical predictions regarding earnings manipulations. In particular we argue that earnings manipulation should be more frequently observed in industries characterized by a high degree of contract incompleteness.
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