No. 139: Performance pay, internal control, and corporate misconduct

We study a situation where an employee chooses productive effort to achieve a target but can also manipulate a performance measure to pretend target achievement and earn an undeserved bonus. Whereas the firm may benefit from undetected manipulation, both the employee and the firm realize a loss in case of detected manipulation. We analyze how performance pay, internal control, and external control (e.g., by a public authority) interact to prevent or promote manipulation. We show that the firm implements internal control to enhance effort but also to induce manipulation more often or at lower costs. Under certain circumstances, both internal and external control reduce the ex ante probability of manipulation by inducing higher effort, which yields a lower failure probability and, thus, a lower probability that manipulation occurs. From a regulatory perspective, a combination of contract regulation, a mandatory internal control system, and high external control is most effective to prevent manipulation.