Why do Corporate Managers Misstate Financial Statements? The Role of Option Compensation and Other Factors

Abstract

We investigate the incentives that led to the rash of restated financial statements at the end of the 1990s market bubble. We find that the likelihood of a misstated financial statement increases greatly when the CEO has very sizable holdings of in-the-money stock options. Misstatements are also more likely for firms that are constrained by an interest-coverage debt covenant, that raise new debt or equity capital, or that 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: M41, M43, M52, J33, G32, G34