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CEO Equity Incentives and Accounting Irregularities

By Harvard Law School Program on Corporate Governance

David F. Larcker is the Director of the Corporate Governance Research Program at the Stanford Graduate School of Business.

In our forthcoming Journal of Accounting Research paper, Chief Executive Officer Equity Incentives and Accounting Irregularities, we examine the relationship between chief executive officer (CEO) equity incentives and accounting irregularities (e.g., restatements, Securities and Exchange Commission Accounting and Auditing Enforcement Releases, and shareholder class action lawsuits). Although equity holdings may alleviate certain agency problems between executives and shareholders, concerns have arisen among researchers, regulators, and the business press that ?high-powered? equity incentives might also motivate executives to manipulate accounting information for personal gain. This view assumes that stock price is a function of reported earnings and that executives manipulate accounting earnings to increase the value of their personal equity holdings. If this allegation is true and the economic cost of accounting manipulation is large, this idea has important implications for executive-compensation contract design and corporate monitoring by both internal and external parties.

We draw inferences regarding the relationship between CEO equity incentives and accounting irregularities from a broad data set. To reduce the potential for ?overt bias,? we employ a propensity-score matched-pair research design to join observations that are similar along a comprehensive set of firm- and manager-level dimensions. The propensity-score method forms matched pairs of CEO firm years that have similar contracting environments but differing levels of CEO equity incentives. This approach alleviates misspecification that occurs when the research design assumes an incorrect functional form for the relationship between the variables of interest (including controls) and the outcome. We also assess the sensitivity of our results to ?hidden bias,? or unobserved correlated omitted variables, using the bounding techniques developed by Rosenbaum (2002). This bounding approach provides insight into the likelihood that our results are confounded by explanations such as endogenous matching of CEOs and equity incentives on the basis of unobserved variables such as the level of CEO risk aversion. Thus, our research design relaxes the assumptions of the traditional matched-pairs approach and assesses the impact of omitted variable and endogeneity concerns.

In contrast to most prior studies, we do not observe a positive relationship between CEO equity incentives and the incidence of accounting irregularities. Instead, our evidence suggests that the level of CEO equity incentives has a modest negative relationship with the incidence of accounting irregularities. This result is more consistent with the notion that equity incentives reduce agency costs that arise with respect to financial reporting, than is the interpretation that equity incentives cause managers to manipulate reported earnings.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on November 30, 2009 (boomark / email).