| The employee stock options offered to executives as a part of their compensation package increase the risk of company officials misrepresenting financial outcomes to rig share prices, according to a new study.
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| If the company’s stock prices rise, the holders of options experience a direct financial benefit, thus giving employees an incentive to behave in ways that will boost the price, according to a new study in Organisation Science, the publication of the Institute for Operations Research and Management Sciences.
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| 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.
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| “This incentive motivates some executives to misrepresent financial outcomes to raise the stock price,” according to 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.”
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| The authors said the results demonstrate two factors that substantially increase the likelihood of financial misrepresentation.
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| These are extremely low performance of the company relative to average performance in the industry and high percentages of CEO compensation in stock options.
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| The study also determined that approximately one out of 10 financial restatements examined by the authors was linked to fraud and illegal practices.
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| “Millions and sometimes tens of millions of dollars worth of CEO compensation ride on these stock options,” explained Bromiley, adding, “That’s enough to motivate some executives to deliberately fudge the books, so that stock prices go up.”
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| The authors found that bonuses had little influence on misrepresentation, unlike stock options. Options offer much greater financial returns to CEOs than bonuses do.
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| The firms with massive losses relative to their assets also tend to misrepresent their financials.
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| The authors examined financial restatements prompted by accounting irregularities identified by the US Government Accountability Office (GAO).
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| The GAO identified 919 such restatements announced between January 1997 and June 2002.
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| According to the GAO, these restatements resulted from “aggressive accounting practices, misuse of facts, oversight or misinterpretation of accounting rules, and fraud.” |
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