Incentive Compensation and the Quality of Disclosure

This paper investigates how executive compensation affects the reliability of the information disclosed to investors. When incentive contracts are based on reported profits, a manager may respond to an increase in incentive compensation by decreasing effort. To both motivate the manager and maintain the quality of disclosure, it is necessary to introduce third-party verification of profits. I analyze an auditor's information acquisition and reporting decisions in two distinct cases: one in which the auditor is independent from the manager and another in which the manager and the auditor form ties through side agreements. When the manager and auditor side contract, the auditor is more likely to knowingly misreport profits, but gains better access to the manager's private information about profits; the net impact on the quality of the auditor's reporting is therefore ambiguous. However, as the manager's incentive compensation increases, collusion between the auditor and manager results in increasingly optimistic profit reports. A policy that raises the penalty imposed on the manager for misreporting profits improves the manager's incentives, but may worsen the auditor's incentives. If the auditor's oversight becomes sufficiently lax, such a policy may actually decrease investor welfare. The model predicts that raising the liability of auditors is more certain to increase the quality of the information disclosed to investors.