Investors typically base executive compensation on performance measures reported by managers and verified by third-party monitors. This paper explicitly examines how compensation influences the reporting behavior of managers and auditors and 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; (3) in contrast to auditors, raising penalties on managers for overstating earnings can reduce audit quality and harm investors; and (4) side agreements between auditors and managers bias auditors, but increase their access to information and may improve investor welfare. These results, in turn, have a number of important implications for the reform of corporate governance.