Executive Compensation and Corporate Fraud

Introduction: The past decade has been witness to some of the worst accounts of corporate fraud ever recorded, with multi-billion dollar companies such as Enron, Tyco, and World-com involved in serious financial scandals. CEOs and senior executives are often the driving force behind such unscrupulous activities by adopting shady accounting practices and other forms of short-termist actions for the purpose of increasing their firm’s stock price and their own personal wealth.

The following paper will investigate whether there is a link between executive compensation structures and fraud or misreporting. Through the analysis of four academic articles, I will show that the evidence which links compensation tools tied to stock market based incentives, and a greater prevalence of corporate fraud, has in fact been mixed. I will conclude by reviewing whether there are any policy implications of these studies. Are Executive Compensation strategies linked to corporate fraud?

Corporate fraud is not a new phenomenon and white collar crimes are as old as white collar professions themselves. However, the significant number and magnitude of criminal offences committed by high powered CEOs and senior executives early on in this young century warrants a closer examination. The articles presented in this study attempt to determine whether there exists a clear link between executive compensation and fraud or misreporting, and the evidence has been mixed: One study finds no link between equity based incentives and fraud (Erickson, Hanlon & Maydew, 2006).

Two studies examine the link between misreporting of accounting statements and CEO stock options, and find a clear correlation between the two, although one of the studies identifies only a limited link. (Burns & Kedia, 2006; Efendi, Srivastava, & Swanson, 2007) The final study concludes that the likelihood of fraud increases when executive compensation is tied to stock market based incentives (Denis, Hanouna & Sarin, 2006). Each study utilizes different methodologies and point to different conclusions. Denis et al. 2006) examine the relationship between firms which utilize stock market based incentives and the prevalence of class action lawsuits and find a correlation between the two. Burns and Kedia (2006) examine the various components of a CEO’s compensation package and finds that there exists a strong correlate between the likelihood of a firm issuing accounting restatements and the use of options based incentives, although they find no link between restricted and equity stock, or any other type of compensation tool.

Burns and Kedia (2006) are not specifically concerned with fraud, but rather misreporting. It is important to distinguish a difference between these two concepts as some unintentional misreporting is not considered fraudulent under the Generally Accepted Accounting Principles (GAAP). Although Efendi et al. (2007) do not label misreporting as fraud, there study is concerned with fraudulent accounting practices. Efendi et al. (2007) find that there exists a greater likelihood of firms misstating financial statements when CEO’s have high proportions of in-the-money stock options.

Finally, Erickson et al. (2006) review 50 firms accused of fraud, with another 50 acting as control, and find no evidence linking equity based incentives with accounting fraud. What is common is that none of the four studies completely condone the use of stock-market based incentives. Denis et al. (2006) points out that there exists ample evidence that executive stock based incentives are positively correlated with increased firm performance, and therefore should not be dismissed so hastily. Erickson et al. 2006) provides evidence supporting the use of equity based incentives, showing how such tools can lead to “firm value maximization. ” Burns and Kedia (2006) add similar sentiments, but do caution that there may be an “optimal level” of stock option use for CEO’s, and anything above this level may provide incentives for misreporting. Efendi et al. (2007) discuss how “option compensation can provide managers with incentives to act in the best interest of the shareholders. ” They (Efendi et al. 2007) contend that there exists considerable evidence extolling the benefits of stock options. In practice, the use of stock options in the corporate sector has increased to account for nearly two-thirds of total pay for CEOs in median firms, a figure that trumps 1984 estimates, where stock options accounted for only 1% of total pay (Denis et al. , 2006). So the question we must ask is when we use stock option based incentives for executives, does the evidence warrant the need for greater controls or regulation? Denis et al. 2006) briefly explores the idea of the need for greater outside monitoring, and discusses how the “dark side” of stock incentive compensation may require robust corporate governance structures to counter-veil the negative effects. Erickson et al. (2006) points out that regulators and policy-makers are quick to link corporate fraud and stock options. They (Erickson et al. 2006) state that the intent of their research was in part to resolve the question as to whether there exists evidence that stock-based compensation is tied to accounting fraud. Since no evidence is found, the policy implications for greater controls are limited.

Burns et al. (2006) study has implications for the level of options and equity in CEO remuneration contracts. Efendi et al. (2007) does not provide any policy recommendations, but do call for further research Conclusion: The central question in this study is whether executive stock based incentives are correlated with fraud or misreporting. Clearly, the results have been mixed. There exists both positives and negative risks associated with this type of compensation tool, but the question as to whether the negative impacts associated with utilizing such pay structures justifies not using them is debatable.

The fact is, none of the articles here advocate that firms should minimize the use of such incentives. As the evidence shows, there is in fact strong coloration between firms which utilize stock based incentives and firm performance, so on the whole, the benefits are quite positive. A balance of strong regulation and anti-fraud measures may be part of the solution in resolving some of the risks. Bibliography: Burns, N. , Simi K. (2006). The impact of performance-based compensation on misreporting, Journal of Financial Economics, 79, 35–67.

Denis, D. , Hanouna, P. , Sarin, A. (2006). Is there a dark side to incentive compensation? Journal of Corporate Finance, 12: 467-488. Erickson, M. , Hanlon, M. , Maydew, E. (2006). Is there a Link between Executive Equity Incentives and Accounting Fraud? , Journal of Accounting Research, 44 (1), 113-143 Efendi, J. , Srivastava, A. , Swanson, E.. (2007). Why do corporate managers misstate financial statements? The role of option compensation and other factors*. Journal of Financial Economics, 85(3), 667-708