Pay-for-performance Sensitivity of CEO Equity Compensation and Financial Misreporting: Evidence from the Personal Wealth Pursuit Motive of CEOs

59 Pages Posted: 13 Jan 2021 Last revised: 2 Jun 2021

See all articles by Wenjiao Cao

Wenjiao Cao

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Yuping Jia

Frankfurt School of Finance & Management gemeinnützige GmbH - Accounting Department

Yachang Zeng

Nanyang Technological University

Date Written: June 1, 2021

Abstract

The incentive effect of CEO portfolio delta (i.e., the sensitivity of CEO wealth to changes in stock price) on financial misreporting is inconclusive given a complex reward-risk tradeoff faced by CEOs (e.g., a positive “reward effect” versus a negative “risk effect”). We propose that the prevalence of CEO hedging pushes the tradeoff more in favor of the “reward effect” side, resulting in a positive net incentive effect of CEO portfolio delta on misreporting. As the tradeoff is associated with a CEO’s explicit focus on personal wealth, we extract unstructured data from the Accounting and Auditing Enforcement Releases (AAERs) for the sample period 20042016 to identify misreporting driven by a CEO’s wealth-pursuing motive. We document that such misreporting is not only widespread in the sample but also positively explained by CEO portfolio delta. Consistent with our theoretical framework, we find that CEO hedging opportunities moderate the positive relationship between CEO portfolio delta and wealth-pursuing misreporting. We also use a simulation to illustrate how including misreporting cases not associated with the reward-risk tradeoff in the analysis might account for the mixed evidence of the delta-AAER association documented by prior studies. Our findings have important implications for compensation design and corporate governance policy.

Keywords: Misreporting; Equity incentive; Wealth-pursuing motive; AAER; CEO portfolio delta; Reward-risk tradeoff

JEL Classification: G34, J33, M41, M43

Suggested Citation

Cao, Wenjiao and Jia, Yuping and Zeng, Yachang, Pay-for-performance Sensitivity of CEO Equity Compensation and Financial Misreporting: Evidence from the Personal Wealth Pursuit Motive of CEOs (June 1, 2021). Nanyang Business School Research Paper No. 21-02, Available at SSRN: https://ssrn.com/abstract=3685697 or http://dx.doi.org/10.2139/ssrn.3685697

Wenjiao Cao (Contact Author)

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

Yuping Jia

Frankfurt School of Finance & Management gemeinnützige GmbH - Accounting Department ( email )

Sonnemannstraße 9-11
Frankfurt
Germany
0049 69 154008 839 (Phone)

Yachang Zeng

Nanyang Technological University ( email )

Singapore, 639798
Singapore

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