Employee stock options offered to executives as part of their compensation package increase the risk of company officials misrepresenting financial outcomes to rig share prices, says a new study.
If the company's stock rises, holders of options experience a direct financial benefit, thus giving employees an incentive to behave in ways that will boost the company's stock price, according to a new study in Organization Science, the publication of the Institute for Operations Research and the Management Sciences.
"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," say Jared Harris of Darden Graduate School of Business Administration, University of Virginia, and Philip Bromiley of Merage School of Business, University of California, in their study titled "Incentives to Cheat: The Influence of Executive Compensation and Firm Performance on Financial Misrepresentation."
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 one in 10 of the financial restatements examined by the authors was linked to fraud and illegal practices. "Over five years, there was a nine per cent likelihood that a company misrepresents its finances and is found out. The actual frequency of misrepresentation is almost certainly higher."
"Millions and sometimes tens of millions of dollars worth of CEO compensation ride on these stock options," explained 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 US Government Accountability Office.
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."
