Performance Pay, Internal Control, and Employee Misconduct

We examine a scenario in which an employee exerts productive effort to achieve a target but can also manipulate a performance measure to falsely claim target achievement. Although manipulation is detrimental from a societal perspective because of its negative externalities, the firm’s shareholders may benefit from undetected manipulation. We analyze the firm’s optimal implementation of internal control and its impact on the employee’s productive effort and manipulative behavior. We demonstrate that a profit-maximizing firm primarily utilizes internal control to enhance the employee’s performance pay contract; however, this does not necessarily reduce manipulation. We identify situations in which internal control reduces or aggravates manipulation and discuss factors that can complement internal control to combat manipulation. This paper was accepted by Suraj Srinivasan, accounting. Funding: This work was funded by the Deutsche Forschungsgemeinschaft (German Research Foundation), Project ID 403041268–TRR 266, Accounting for Transparency and under Germany’s Excellence Strategy, EXC 2126/1–390838866. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2023.04232 .