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 Classification: M14, M41, M43, M52, K22, J33, G34