The sun always rises. Time is unidirectional. Financial wealth can beget greed. All are fundamental truths of the universe. With regard to the last, is it possible to theorize on the link between performance-based corporate executive compensation and accounting fraud? How do we determine what separates Chief Executive Officers (CEO) such as Jeffery Skilling and Kenneth Lay from the failed conglomerate Enron from perceived highly successful CEO’s such as Jack Welch at General Electric? All of the former corporate executives were handsomely compensated in company stock options, so is it really possible to derive a correlation between corporate pay metrics and fraud? We dive deeper for answers.
Stock Options Rising as a Percentage of Total Pay
A 2014 Harvard University study concluded that the average CEO compensation makeup for a Standard & Poor’s 500 company was comprised of 57.2 percent stock award and options. This statistic asserts that the average S&P 500 corporation compensates its CEO primarily through a channel directly associated with the company’s financial performance. The same study concluded that only 11.6 percent of the median compensation package for a CEO of an S&P 500 company was through his or her base salary.
Linking Empirical Evidence
In 2007, Jared Harris and Philip Bromiley, professors at Darden and Merage business schools respectively, conducted a study on the link between option based executive compensation and financial misrepresentation. Using data from the then General Accounting Office (GAO), the professors analyzed 919 restatements by 845 firms from January 1997 through June 2002. They concluded that the average restatement percentage over a five year period was 8.8 percent. When the compensation for a CEO (often a metric for other executive pay) is more than 92 percent option-based that number jumps to a 21 percent chance of restatement in a five year window. The most dramatic increase comes when executive compensation is above 76 percent option-based.
While there has been much written about the potential interconnection between executive stock options and accounting fraud, the role of options in financial misreporting has a lesser known effect that remains just as profound. In a 2015 updated version of the original paper, which won the 2011-2012 Glen McLaughlin Prize for Research in Accounting and Ethics from the University of Oklahoma, it was determined that stock options had discouraged whistleblowing on financial misreporting. The paper, written by Andrew Call, Simi Kedia, and Shivaram Rajgopal of Arizona State, Rutgers, and Columbia respectively, concluded that “violating firms grant more rank and filed options during periods of misreporting.” In simple terms, businesses were more likely to grant options during periods of wrongdoing to tie potential whistleblowers to the company’s stock price (i.e. they had “skin in the game").
Analyzing Future Trends
It is reasonable to expect the continuation of large stock (and stock option) packages to encompass greater and greater portions of total executive compensation due their liquidity neutrality and emphasis on driving up the company equity share price. However, the strength and effectiveness of corporate governance regulations are becoming increasingly uncertain. While the intertwined reality of stock options and accounting fraud is likely to persist, it is impossible to even speculate on its prevalence in the coming years. It is plausible that the means to reach earnings goals will evolve from reporting manipulation to operational maneuvers, such as postponing year end purchases to the succeeding fiscal year. Regardless, the path to financial prosperity for some corporate executives likely remains tied to corporate stock options and the ever enticing quicksand of fraudulent accounting.
By: Todd Cheney, CPA, Accounting Policy and Practice Editor
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