Contract Disclosure, Earnings Management, and External Enforcement

Abstract

We examine the effects of mandating compensation disclosure on executive incentive contracts, earnings management, firm value, and social welfare. We develop a moral hazard model with multiple principal-agent pairs facing a representative investor who allocates resources across firms to uncover earnings management. With such scrutiny allocation, contracts exhibit externalities that create a coordination problem among principals. Contract disclosure provides principals with a first-mover advantage, allowing them to design the contract anticipating the investor's reaction. However, it may also exacerbate the coordination problem among principals as they do not consider externalities on other principals caused by the effects of their contract choices on the investor's scrutiny allocation. We find that, if internal controls are relatively weak, contract disclosure may make contracts more strongly contingent on reported earnings, increase earnings manipulation, and nevertheless increase social welfare. However, contract disclosure improves firm value only if the scrutiny resources available to the investor are not strongly constrained.