Study: As executive stock options rise, so does fraud, financial shenanigans

Executive stock options many times lead to increased company financial fraud. A study released today says companies whose management incentives consisting mainly of stock options strongly increase the likelihood of financial shenanigans. The authors examined financial restatements prompted by accounting irregularities identified by the U.S. Government Accountability Office (GAO). The GAO identified 919 such restatements at 845 companies 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.   The GAO said: “ This number represents a “significant portion” (10 percent) of publicly traded companies. The restatement trend has also shifted toward larger companies, as the median market capitalization of restating companies increased from $500 million in 1997 to $2 billion in 2002.” Today’s  study also said approximately 1 in 10 of the financial restatements examined by the authors was linked to fraud and illegal practices. Over five years, there was a 9% likelihood that a company misrepresents its finances and is discovered.  The actual frequency of misrepresentation is almost certainly higher, the study said. 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, the study said. “Incentives to Cheat: The Influence of Executive Compensation and Firm Performance on Financial Misrepresentation,” by Jared Harris, the Darden Graduate School of Business Administration, University of Virginia, and Philip Bromiley, Merage School of Business, University of California, Irvine, appears in the current issue of Organization Science. “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 authors said in a  statement.  “Millions and sometimes tens of millions of dollars worth of CEO compensation ride on these stock options,” explained Bromiley in a statement. “That’s enough to motivate some executives to deliberately fudge the books so that stock prices go up.” The authors found bonuses made little difference:  “Unlike with stock options,” they wrote, “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. Certainly the high-tech industry has been rife with financial restatements.  Just this year RIM, Nortel, Juniper, CA and others have had problems.  Apple too has had an ongoing issue.  And just this week four former executives with Enterasys Networks  were sentenced to prison terms for their roles in accounting fraud at the company that cost investors millions of dollars, the U.S. Department of Justice said. Also this year the U.S. Supreme Court said Bernard Ebbers, former CEO at WorldCom, will remain in prison to serve out his 25-year sentence for fraud.  The court turned down an appeal by Ebbers today without comment. The appeal was based on Ebbers’ belief he did not receive a fair trial because potential defense witnesses were not offered immunity as were prosecution witnesses.