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1 August 2009 CFA Institute Journal Review

Managerial Incentives and Corporate Fraud: The Sources of Incentives Matter (Digest Summary)

  1. Derek W. Johnson, CFA

The authors examine various types of equity-based compensation, such as unrestricted stock, restricted stock, and stock options, and their unintended consequence of enticing managers to commit fraud. Unrestricted stock tends to have a linear relationship with the value of the stock as opposed to stock options, which have a convex relationship with the value of the stock. The linear relationship results in a greater financial loss if the company’s stock price declines. The authors conclude that the greater loss potential in unrestricted stock can tempt corporate executives to commit fraud to prevent a loss in value. Additionally, the authors find that executives are more likely to commit fraud when the chances of getting caught are low. Finally, companies with high sales growth as well as those that have a higher percentage of insiders sitting on the audit committee have a lower likelihood of detecting and reporting fraud. The authors conclude that companies should examine the effects of equity-based compensation packages in aligning the interests of all the stakeholders in both the short and the long run.

The authors question whether equity-based incentives offered by corporations encourage some executives to commit fraud. Equity-based incentives, such as bonuses issued with restricted or unrestricted stock and stock options, help align managers’ interest with that of shareholders. The authors find, however, that the incentives may have the unintended consequence of enticing some managers to commit fraud. The motivation to commit fraud may be the result of the managers attempting to mitigate personal loss in net worth caused by a drop in stock values because of a decline in operational corporate performance.

Companies may compensate managers with various kinds of ownership-type incentives. These incentives include unrestricted stock, which managers can hold or sell at any time; restricted stock, which managers are not allowed to sell for a certain period of time; or stock options, which managers can exchange for shares of stock. Options are more valuable if the stock price is above the price for which the options can be exchanged, also known as the strike price. When the stock price is below the strike price, the option has less value. Unrestricted stock has a linear relationship with a manager’s wealth because for every drop in price, the manager’s net worth also drops. An option, however, has more of a convex relationship with a manager’s wealth: A drop in value of the stock will have a linear relationship while the stock is above the strike price, but as the price declines, the decline in wealth is not as severe. Restricted stock is not as much of a concern because executives cannot sell and thereby benefit from the fraud until the stock becomes unrestricted. The authors find that unrestricted stock gives the most opportunity for managers to commit fraud as they attempt to mitigate any losses that might occur as a result of a loss in market value.

The authors examine companies that were subject to Accounting and Auditing Enforcement Releases (AAERs) by the U.S. SEC from 1991 to 2005. They compare these “fraud companies” with a control set of companies that are based on similar metrics, such as industry and size, but were not subject to AAERs. The authors look at the types of incentives awarded by the fraud companies versus the control group. They find that for the median fraud executive, incentives of unrestricted stock are 54 percent greater than the incentives for the median control executive. The fraud companies were more likely to issue unrestricted stock, whereas the control companies were more likely to issue stock options. The authors opine that corporate managers protect themselves through the use of fraud to mitigate the higher potential loss with unrestricted stock.

The authors also discover other factors that help predict a manager’s propensity to commit fraud. Managers will use fraud when they believe the likelihood of getting caught and punished is low. The fraud companies had higher sales growth than the control group, and other studies show that fraud is harder to detect in companies with high sales growth than in companies with moderate to low sales growth. The authors also find that the fraud companies have a greater percentage of insiders on the audit committee compared with the control companies. Because the audit committee is in charge of the oversight of accounting procedures, managers might think that having more insiders on the committee will prevent the detection and, more importantly, the reporting of suspected fraud.

Proper incentives are an important process in aligning corporate managers’ interests with those of shareholders in maximizing company values. The authors find, however, that some equity-based incentives more than others encourage fraud. Unrestricted stock has more of an impact on managers’ net worth than options or restricted stock. This greater impact could drive a manager to commit fraud in an effort to prop up stock values in the face of declining corporate profitability. The authors conclude that corporate boards should use this information in providing optimal equity-based compensation packages that align all stakeholders’ best interests both in the short and long term.

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