This paper examines how performance-based compensation for managers influences
their reporting behavior and the resulting stance auditors take when
deciding whether to certify a manager�s report. The paper makes endogenous
the stance auditors take: with a more conservative stance, auditors are less
likely to certify an inflated report, but are more likely to refuse to certify an
accurate one. The auditor�s tradeoff between these two error types, and the
resulting interplay with the level of performance-based pay for managers, play
a critical role in determining the level of managerial misreporting, investor welfare,
and a number of other key variables. The paper finds that (1) strengthening
the link between pay and reported performance can result in a weaker link between
pay and actual performance and, consequently, lower managerial effort;
(2) conservatism among auditors improves performance measurement; and (3)
raising penalties on managers for overstating earnings can reduce audit quality
and harm investors, while raising penalties on auditors for certifying overstated
results does not harm investors.