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Incentive Compensation and Fraud Allegations Case Study

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Updated: Jul 15th, 2020


The newly occurred practice among the US top managers is to transform the stock options of the CEOs into the equity-based compensations. Since the proportion of equity compensation reached one-third of the executives’ choice of stock options, the use of such a method is considered controversial (Hall 23). The main reason for the controversy is that there are several cases where types of executives’ compensations can be linked to the fraud allegations in their companies. Another important aspect of this practice is the relationships between the allegations against the executives and the option intensity of their payments (Denis, Hanouna and Sarin 468).

On one hand, the opportunities for the CEOs to introduce the equity-based payoffs and the system of option intensity compensation depend on the size of the company and the quantity of the block-holders amongst the investors and stakeholders (Merton 155). In other words, the option intensity is more common for the CEOs of the companies, who have a larger number of the outside financial agents such as investors and shareholders of different sizes. On the other hand, the companies directed by the shareholders from the outside would be more likely to discharge the manager because of the firm’s poor financial performance.

Hypothesis development

The hypothesis is based on the fact that poor performance leads more often to the manager’s dismissal in the companies with the directors and stakeholders not involved in financial reporting. Also, equity-based compensation is the opportunity for the managers to receive the payoffs that would depend on the company’s performance. The option intensity is meant to make the compensations as quickly as possible. Therefore, the main hypothesis is that the presence of a large number of the block-holders among the company’s directors and the equity-based system of compensation increase the possibility of misreporting and fraud among the CEOs (Denis, Hanouna and Sarin 470).

There are two possibilities of how the likelihood of misreporting of financial results relates to the company’s structure. Firstly, in the case of the outsider directors and other stakeholders, it is important to sustain the integrity of the company’s management (Healy 102). This aspect has two implications. The company’s executives are more likely to have the option intensity when there is a significant risk of dismissal in case of the poor performance, and the disintegrated directors are less aware of the manager’s actions and the details of the financial performance. Secondly, even though equity-related compensation is the dominant option in the institutional companies with a lot of stakeholders, the relation of such an option to the fraud allegation cannot be viewed as a direct one (Bethel, Liebeskind and Opler 611).

Thus, the executives who are involved in the pernicious earnings management are tempted by the payoffs of the fraud (Healy and Wahlen 369). However, without empirical evidence, their practice cannot be related to the equity-based payments as such because, in many cases, especially when the benefits of the managers depend on the company’s performance, the option intensity is the most effective one.

Sample description

In the study designed by Denis, Hanouna, and Sarin (2006), the database for defining correlations between the executives’ fraud allegations and equity compensations used the information about the 358 companies (Denis, Hanouna and Sarin 468). For most of the sample companies, the fraud allegations involved the misrepresentation of financial information that created a misleading impression about the company’s financial results and overall performance. The important aspect is that the companies with the equity ownership of both the executives and the outside stakeholders showed no direct correlation to the fraud actions and earnings management.

The option incentives and fraud allegations

Another important aspect of the analysis is the relationships between the alleged fraud and the option of stock incentives, such as the equity option. It is a regular practice for the companies to include the currently granted options and the options from the previous fiscal period into the portfolio of the executive. Therefore, the option intensity can be calculated proportionally based on those measures by dividing the amount of the granted options in the current year by the amount of the stock shares in the executive’s ownership (Denis, Hanouna and Sarin 477).

Ownership structure, board structure, and fraud allegations

The correlations between the ownership of the company, including the equity ownership of the top managers, the board of directors and the distant outsider stakeholders can be interpreted in two ways. First of all, the amount of lawsuits to the CEOs concerning the fraud allegations stands concerning the type of equity ownership. Secondly, the board and the shareholders less control the benefits and payoffs of the executives when the option incentive is involved.

Summary and implications

In conclusion, the correlation between the fraud allegations and the equity options incentives is likely to have the causal nature to it. The executives of the companies with outsider directors and the equity-based compensation are more involved in misreporting and fraud. Nonetheless, it is important to conduct further analysis concerning the likelihood of earnings management among the executives that can be avoided through discarding the option incentives and equity-based type of the CEOs’ compensations.

Works Cited

Bethel, Jennifer E., Julia Liebeskind, and Tim Opler. “Block Share Purchases and Corporate Performance.” The Journal of Finance 53.2 (1998): 605-634. Print.

Denis, David J., Paul Hanouna, and Atulya Sarin. “Is There a Dark Side to Incentive Compensation?” Journal of Corporate Finance 12.3 (2006): 467-488. Print.

Hall, Brian J. “Six Challenges in Designing Equity-based Pay.” Journal of Applied Corporate Finance 15.3 (2003): 21-33. Print.

Healy, Paul M. “The Effect of Bonus Schemes on Accounting Decisions.” Journal of Accounting and Economics 7.1 (1985): 85-107. Print.

Healy, Paul M., and James M. Wahlen. “A Review of the Earnings Management Literature and Its Implications for Standard Setting.” Accounting Horizons 13.4 (1999): 365-383. Print.

Merton, Robert C. “Theory of Rational Option Pricing.” The Bell Journal of Economics and Management Science 1.2 (1973): 141-183. Print.

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