The Relation between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives

61 Pages Posted: 21 Oct 2012 Last revised: 8 Jun 2013

Chris Armstrong

University of Pennsylvania - Accounting Department

David F. Larcker

Stanford University - Graduate School of Business

Gaizka Ormazabal

University of Navarra, IESE Business School

Daniel J. Taylor

University of Pennsylvania - The Wharton School

Date Written: November 20, 2012

Abstract

Prior research argues that a manager whose wealth is more sensitive to changes in the firm’s stock price has a greater incentive to misreport. However, if the manager is risk-averse and misreporting increases both equity values and equity risk, the sensitivity of the manager’s wealth to changes in stock price (portfolio delta) will have two countervailing incentive effects: a positive “reward effect” and a negative “risk effect.” In contrast, the sensitivity of the manager’s wealth to changes in risk (portfolio vega) will have an unambiguously positive incentive effect. We show that jointly considering the incentive effects of both portfolio delta and portfolio vega substantially alters inferences reported in prior literature. Using both regression and matching designs, and measuring misreporting using discretionary accruals, restatements, and SEC Accounting and Auditing Enforcement Releases, we find strong evidence of a positive relation between vega and misreporting and that the incentives provided by vega subsume those of delta. Collectively, our results suggest that equity portfolios provide managers with incentives to misreport when they make managers less averse to equity risk.

Keywords: Equity Incentives, Executive Compensation, Misreporting, Earnings Management, Restatements, SEC Enforcement Actions

JEL Classification: J33, G34, M41, M52

Suggested Citation

Armstrong, Chris and Larcker, David F. and Ormazabal, Gaizka and Taylor, Daniel J., The Relation between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives (November 20, 2012). Journal of Financial Economics (JFE), 109 (August 2013): 327-350.; Rock Center for Corporate Governance at Stanford University Working Paper No. 126; Stanford Graduate School of Business Research Paper No. 2120. Available at SSRN: https://ssrn.com/abstract=2164768

Chris S. Armstrong

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

David F. Larcker

Stanford University - Graduate School of Business ( email )

Graduate School of Business
518 Memorial Way
Stanford, CA 94305-5015
United States
650-725-6159 (Phone)

Gaizka Ormazabal

University of Navarra, IESE Business School ( email )

Avenida Pearson 21
Barcelona, 08034
Spain

Daniel Taylor (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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