2025 Volume 33 Issue 1 Pages 115-137
The purpose of this paper is to highlight the importance of designing compensation contract in corporate governance by exploring the relationship between shareholder (principal) and manager (agent) based on the principal-agent model. It proposes a novel approach to compensation system based on self-reporting. The paper models the accuracy of performance indicator as the product of the control environment, control ability, and control activity. It demonstrates that by designing compensation contract that incorporate a mechanism for automatically adjusting accuracy to an appropriate level based on the agent’s self-reported control ability, the principal’s expected utility can be maximized. Furthermore, it shows that when the agent’s self-reported value is relatively low, the principal can further maximize expected utility by considering a shift from a compensation contract based on self-reporting to one that does not rely on self-reporting, and by declaring this possibility to the agent in advance. This approach suggests that the integration of internal controls and compensation system contributes to improved corporate governance outcomes.
