Management incentives consisting mainly of stock options strongly increase the likelihood of financial misrepresentation, according to a new study in a publication of the Institute for Operations Research and the Management Sciences (INFORMS®).
"Incentives to Cheat: The Influence of Executive Compensation and Firm Performance on Financial Misrepresentation," by Jared Harris, the Darden Graduate School of Business Administration, University of Virginia, and Philip Bromiley, Merage School of Business, University of California, Irvine, appears in the current issue of Organization Science, an INFORMS publication.
According to the authors, "Our results demonstrate two factors substantially increase the likelihood of financial misrepresentation: extremely low performance relative to average performance in the firm's industry, and high percentages of CEO compensation in stock options."
The study also determined that approximately 1 in 10 of the financial restatements examined by the authors was linked to fraud and illegal practices. Over five years, there was a 9% likelihood that a company misrepresents its finances and is found out. The actual frequency of misrepresentation is almost certainly higher.
Stock options offer a strong incentive to raise the stock price above the strike price; indeed, the stock price must rise above the strike price for executives to profit from their options. This incentive motivates some executives to misrepresent financial outcomes to raise the stock price.
"Millions and sometimes tens of millions of dollars worth of CEO compensation ride on these stock options," explained Prof. Bromiley. "That's enough to motivate some executives to deliberately fudge the books so that stock prices go up."
The authors found bonuses had little influence on misrepresentation. "Unlike with stock options," they write, "we found no significant influence of bonuses on financial misrepresentation." They note that options and bonuses offer different incentives and that options offer massively greater financial returns to CEO's than bonuses do.
In addition to firms with high levels of stock options, firms with massive losses relative to their assets also tended to misrepresent their financials. The authors examined financial restatements prompted by accounting irregularities identified by the U.S. Government Accountability Office (GAO). The GAO identified 919 such restatements announced between January 1997 and June 2002. According to the GAO, these particular restatements resulted from "aggressive accounting practices, misuse of facts, oversight or misinterpretation of accounting rules, and fraud."
The Institute for Operations Research and the Management Sciences (INFORMS®) is an international scientific society with 10,000 members, including Nobel Prize laureates, dedicated to applying scientific methods to help improve decision-making, management, and operations. Members of INFORMS work in business, government, and academia. They are represented in fields as diverse as airlines, health care, law enforcement, the military, financial engineering, and telecommunications. The INFORMS website is www.informs.org. More information about operations research is at www.scienceofbetter.org.