We study a model of financial reporting where investors infer the precision of reported earnings. Reporting a larger earnings surprise reduces the inferred earnings precision, dampening the impact on firm value of reporting higher earnings, and providing a natural demand for smoother earnings. We show that for sufficiently “bad” news, the manager under‐reports earnings by the maximum, preferring to take a “big bath” in the current period in order to report higher future earnings. If the news is “good,” the manager smoothes earnings, with the amount of smoothing depending on the level of cashflows observed. He either over‐reports or partially under‐reports for slightly good news, and gradually increases his under‐reporting as the news gets better, until he is under‐reporting the maximum amount for sufficiently good news. This result holds both when investors are “naïve” and ignore management’s ability to manipulate earnings, or “sophisticated” and correctly infer management’s disclosure strategy.

This paper studies how to assign “monitors” to productive agents in order to generate signals about the agents' performance that are most useful from a contracting perspective. We show that if signals generated by the same monitor are negatively (positively) correlated, then the optimal monitoring assignment will be “focused” (“dispersed”). This holds because dispersed monitoring allows the firm to better utilize relative performance evaluation. On the other hand, if each monitor communicates only an aggregated signal to the principal, then focused monitoring is always optimal since aggregation undermines relative performance evaluation. We also study team‐based compensation and randomized monitoring assignments. In particular, we show that the firm can gain from randomizing the monitoring assignment, compared with the optimal linear deterministic contract. Furthermore, under randomization, the conditional expected utility for the agent is higher when the agent is not monitored compared with the case where the agent is monitored. That is, the chance of being monitored serves as a “stick” rather than a “carrot”.