Managers' Compensation and Misreporting. A Costly State Verification Approach

We look for the optimal shareholder-manager contract, able to induce the latter to exert high effort and truthfully reveal firm performance. This twofold incentive compatibility constraint calls for a convex compensation scheme (a fixed wage plus a state contingent claim) coupled with a state contingent verification (audit). A natural way to implement such a compensation scheme is through stock options. In order to reduce the expected verification cost, an optimal stock option plan assigns the manager a large number of options with high strike price. The recent decline in the use of stock options could be interpreted in terms of an insufficiently focused auditing. It is suggested that improving the design of the audit activity (and supervision) is a better solution to the problem of misreporting than giving up stock options as a compensation tool.