The optimal shape of compensation contracts with earnings management

The research question of why earnings management occurs is decomposed into two questions in this article: Which component of executive compensation generates incentives for earnings management? and Why is the compensation structured that way in the first place? We first use as a dynamic stochastic equilibrium model to show that ‘big bath’ and earning overstatement can co-exist as equilibrium financial reporting strategies when thresholds are used in compensation contracts. In order to understand the use of performance thresholds as a prevailing compensation strategy in practice, we then derive the optimal compensation contract when the manager is privately informed about economic earnings and his expertise in managing earnings. Equilibria exist in which the inactive region below a threshold in compensation should be economically significant.