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Bridge over ocean
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.