Monitoring, Incentive Contracting, and Accounting Manipulation

This study examines how a monitoring system that constrains accounting manipulation a¤ects shareholder value and managerial rents. Although it is generally argued that constraining manipulation via monitoring alleviates e¤ort control problems, this study demonstrates that monitoring can make it harder, not easier, to induce managerial e¤ort. The key intuition is that when investment outcomes are contractible, management’s manipulation incentives increase in the level of productive e¤ort. This result implies that restricting manipulation via monitoring can increase the cost of incentive contracting, which reduces shareholder value. In addition, monitoring discourages managers from engaging in costly manipulation activities and thus can increase managerial rents. The analysis also shows that monitoring can increase shareholder value and managerial rents simultaneously, suggesting that shareholders and managers do not always disagree on the optimal monitoring system.