Endogenous Compensation in a Firm with Disclosure and Moral Hazard

Abstract

I model a firm where shareholders choose the manager's compensation in light of the manager's dual roles of exerting effort and making disclosures regarding the firm's value. Because of limited contracting ability and the divergence of short-term interest between shareholder and manager, shareholders may be unable to obtain their first-best choices of effort and disclosure policy; where agency costs are too large, shareholders will be unwilling to award performance-based compensation, which induces both effort and fraudulent reporting. The principal findings are (1) fraud and effort are positively correlated, and given a poor outcome fraud is more likely to obtain when effort is exerted in equilibrium, (2) the incidence of fraud-inducing compensation increases as agency costs decrease, and (3) reductions in agency costs actually increase the incidence of fraud when agency costs are high.