Monitoring, incentive contracting, and accounting manipulation
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This study examines how a monitoring system that constrains accounting manipulation affects shareholder value and managerial rents. Although it is generally argued that constraining manipulation via monitoring alleviates effort control problems, this study demonstrates that monitoring can make it more, not less, costly to induce high managerial effort. The key intuition is that the optimal contract incentivizes managers to manipulate accounting reports to influence project continuation decisions. More importantly, when manipulation is costly, management's manipulation incentives increase in the level of productive effort. This result implies that allowing accounting manipulation can make it more attractive for managers to exert high productive effort. Consequently, 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.