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
Date Written: June 1, 2021
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 20042016 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: Suggested Citation