The Relation between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives

By Christopher S. Armstrong, David F. Larcker, Gaizka Ormazabal, Daniel J. Taylor. 2013

430 citations recorded by the source corpus.

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 enforcement actions, 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.

Subfields: Accounting, Finance

View Paper: https://www.semanticscholar.org/paper/ea075b21bebc4b60eef8cbb03b3ac94f6bbc8d96

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Citations in the corpus

Rank and File Employees and the Discovery of Misreporting: The Role of Stock Options (2016, positive): “A related literature documents the role of compensation and managerial behavior in misreporting (Burns and Kedia, 2006; Armstrong et al., 2010; Armstrong et al., 2013; Bushee, 1998; Schrand and Zechman, 2012).”
Tournament Incentives and Corporate Fraud (2015, methodology): “With respect to the control variables, we find that sales growth is significantly positively associated with the propensity to engage in fraud in line with Armstrong et al. (2013).”
Internal Governance and Real Earnings Management (2016, background): “in real earnings management to meet earnings targets (Skinner and Sloan 2002; Erickson et al. 2006; Armstrong et al. 2012).”
The effect of CEO inside debt holdings on financial reporting quality (2015, background): “Ashbaugh-Skaife et al. (2009) and Kim et al. (2011) also contend the positive impact of effective internal control on the quality of financial reporting.”
Equity Incentives and Corporate Fraud in China (2015, methodology): “On the one hand, a positive effect has been found in, for example, Bergstresser and Philippon (2006), Burns and Kedia (2006), and Armstrong et al. (2013).”
Corporate Governance, Incentives, and Tax Avoidance (2015, background): “On the other hand, Armstrong et al. (2013) note that delta also “amplifies the effect of equity risk on the total riskiness of the manager’s portfolio,” which discourages risk-averse managers from pursuing risky projects.”
CEO Equity Incentives and Audit Fees (2015, methodology): “Earnings management has been shown to increase firm risk (e.g., Pastor and Veronesi 2003; Rajgopal and Venkatachalam 2011; Armstrong et al. 2013).”
The Impact of CEO Narcissism on Earnings Management (2018, neutral): “In contrast to findings by Armstrong et al. (2013) and Bergstresser and Philipon (2006), the coefficients for firm age and return on assets are significant and positive.”