The Relation between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives
University of Pennsylvania - Accounting Department
David F. Larcker
Stanford University - Graduate School of Business
University of Navarra, IESE Business School
Daniel J. Taylor
University of Pennsylvania - The Wharton School
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
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.
Number of Pages in PDF File: 61
Keywords: Equity Incentives, Executive Compensation, Misreporting, Earnings Management, Restatements, SEC Enforcement Actions
JEL Classification: J33, G34, M41, M52
Date posted: October 21, 2012 ; Last revised: June 8, 2013