The impact of performance-based compensation on misreporting

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jfineco.2004.12.003 Byline: Natasha Burns (a), Simi Kedia (b) Keywords: Restatements; Misreporting; Compensation; Options Abstract: This paper examines the effect of CEO compensation contracts on misreporting. We find that the sensitivity of the CEO's option portfolio to stock price is significantly positively related to the propensity to misreport. We do not find that the sensitivity of other components of CEO compensation, i.e., equity, restricted stock, long-term incentive payouts, and salary plus bonus have any significant impact on the propensity to misreport. Relative to other components of compensation, stock options are associated with stronger incentives to misreport because convexity in CEO wealth introduced by stock options limits the downside risk on detection of the misreporting. Author Affiliation: (a) Terry College of Business, The University of Georgia, Athens, GA, 30602, USA (b) Rutgers Business School, Rutgers University, Newark, NJ, 07102, USA Article History: Received 17 September 2003; Revised 12 August 2004; Accepted 6 December 2004 Article Note: (footnote) [star] This paper combines the results of two earlier papers: 'Does performance-based compensation explain restatements' by Natasha Burns and 'Do stock options generate incentives for earnings management? Evidence from accounting restatements' by Simi Kedia. We thank Jean Helwege, Andrew Karolyi, and Rene Stulz for their comments and advice. We also thank Jim Hsieh, Kose John, Steven Kaplan, Kevin Murphy, Prabhala, Jeremy Stein, Christof Stahel, Ralph Walking, Karen Wruck, David Yermack, participants at the 2003 NBER Universities Research Conference of Corporate Governance, the 2004 AFA Meetings in San Diego, seminars in Arizona State University, Baruch College, Indiana University, Ohio State University, Penn State University, Rice University, Rutgers University, Southern Methodist University, University of Georgetown, University of Houston, University of Illinois, and University of Pittsburgh for helpful comments. Kim Haufrect and Mihail Miletkov provided excellent research assistance. We are very thankful for the comments and suggestions of an anonymous referee. All errors are the responsibility of the authors.