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CEOs on the Edge: Earnings Manipulation and Stock-based Incentive Misalignment

Sep 01, 2008

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Publicly traded companies have long used stock options as a form of executive compensation, with the goal of discouraging undesirable behavior by tying a CEO’s personal interests with that of shareholders. But the impact of stock options may be more negative than positive, according to research by Kathryn M. Bartol, Robert H. Smith Professor of Management & Organization, and Ken G. Smith, Dean’s Chaired Professor of Business Strategy, with co-authors Dmitry M. Khanin, Cal State, Fullerton; Michael D. Pfarrer, University of Denver; and Xioameng Zhang, American University.

Previous research focused on earnings manipulation at the industry or firm level, but Bartol and Smith looked at CEO compensation. They analyzed data from 2,532 public companies from 1996 to 2001, using a U.S. General Accounting Office restatement database to identify restatement announcements from 225 companies. Since earnings manipulation occurs before restatement announcements, the authors conducted additional medial and financial statement research, identifying 365 earnings manipulation cases.

The authors drew on existing theories centered on stock-based managerial incentives to create seven hypotheses. Agency-based theory predicts self-interested individuals will behave in a way that maximizes their personal utility, which may cause harm to shareholders. Thus, stock-based incentives are advocated as a method that aligns a CEO’s self-interests with that of his or her shareholders. Prospect theory argues decision makers are loss averse, because they will forgo the risk of a gain if it incorporates the perceived potential for loss relative to their current position.

The intersection of prospect and agency theory leads to the insight that a decision maker’s risk preferences are heavily influenced by their fear of loss relative to their existing wealth. And as a result, incentives like stock options may not serve as the desired “risk preferences,” instead leading to financial misalignments.

“CEOs on the Edge: Earnings Manipulation and Stock-based Incentive Misalignment,” is the first paper to demonstrate that out-of-the-money and in-the-money options have different impacts on earnings manipulation as it involves CEOs. It also examines the effects of firm performance and CEO tenure on CEO decisions to engage in earnings manipulation. CEOs were more likely to manipulate firm earnings when they had higher levels of out-of-the-money stock options, and when they had lower levels of stock ownership. This suggests that under certain conditions, stock-based managerial incentives can cause CEO incentive misalignment, which can lead to negative consequences including earnings manipulation.

The study concluded that out-of-the-money options were positively related to earnings manipulation. These options place executives in a perceived loss situation, making CEOs more likely to take aggressive actions to minimize losses. When firm performance was considered, CEOs with larger amounts of out-of-the-money options under low performance conditions were most likely to engage in earnings manipulation. Surprisingly, the authors found longer-tenured CEOs, instead of newly appointed CEOs, with larger amounts of out-of-the-money options, were the most likely to manipulate firm earnings.

Future research might consider top management executives’ pay packages, since earnings manipulation is likely to involve multiple players. It may also investigate differences in pay packages among CEOs who are promoted to their positions versus external candidates.

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