The Contract Disclosure Mandate and Earnings Management under External Scrutiny

Abstract

This paper studies the effects of mandating compensation disclosure on executive incentive contracts, and the ensuing effects on earnings management, and shareholders' and social welfare. We develop a moral hazard model with multiple principal-agent pairs facing an external inspector who allocates resources across firms to uncover and penalize earnings management. Contract disclosure confers principals with a first-mover advantage, allowing them to design the contract anticipating the inspector's reaction. However, it may also exacerbate a coordination problem among principals, as they do not consider externalities on other principals caused by the effects of their contract choices on the inspector's scrutiny allocation. We find that, if the penalty the inspector imposes on executives is relatively harsher than that imposed on shareholders, contracts become more strongly contingent on reported earnings, earnings are more severely manipulated, and social welfare increases with contract disclosure. However, disclosure improves shareholders' welfare only if the scrutiny resources available to the inspector are not strongly constrained.