Why Do Corporate Managers Misstate Financial Statements? the Role of Option Compensation and Other Factors

Abstract:     
We investigate incentives that led to the rash of restated financial statements at the end of the 1990s market bubble. We find the likelihood of a misstated financial statement increases greatly when the CEO has very sizable holdings of stock options "in-the-money" (i.e., stock price above exercise price). Misstatements are also more likely for firms that are constrained by an interest-coverage debt covenant, raise new debt or equity capital, or have a CEO who serves as board chair. Our results indicate that agency costs increased (Jensen 2005a) as substantially overvalued equity caused managers to take actions to support the stock price.

Keywords: restatements, stock options, executive compensation, agency theory, overvalued equity

JEL Classifications: M14, M41, M43, M52, K22, J33, G34

Working Paper Series