The Relation between Equity Incentives and Misreporting

The following post comes to us from Christopher Armstrong and Daniel Taylor, both of the Department of Accounting at the University of Pennsylvania; David Larcker, Professor of Accounting at Stanford University; and Gaizka Ormazabal of the Department of Accounting and Control at the University of Navarra, IESE Business School.

A large body of prior literature examines the relation between managerial equity incentives and financial misreporting but reports mixed results. This literature argues that a manager whose wealth is more sensitive to changes in stock price has a greater incentive to misreport. However, if managers are risk-averse and misreporting increases both equity values and equity risk, managers face a risk/return tradeoff when making a misreporting decision. In this case, the sensitivity of the manager’s wealth to changes in stock price, or 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 equity portfolio to changes in risk, or portfolio vega, will have an unambiguously positive incentive effect. Accordingly, when managers are risk-averse, it is important to jointly consider both portfolio delta and portfolio vega when assessing the relation between equity incentives and misreporting.

In our paper, The Relation Between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives, forthcoming in the Journal of Financial Economics, we show that jointly considering both portfolio delta and portfolio vega substantially alters inferences reported in the literature. Specifically, we find inferences in studies reporting either a positive relation or no relation between portfolio delta and misreporting are not robust to controlling for vega.

Using both regression and matching designs, and measuring misreporting using discretionary accruals, restatements, and SEC Accounting and Auditing Enforcement Releases, we find strong evidence of a positive relation between portfolio vega and misreporting and that the incentives provided by portfolio vega subsume those of portfolio delta. We continue to find a positive relation between vega and misreporting when we include firm fixed effects in our regression specifications and no incremental relation between delta and misreporting. This suggests that variation in risk-taking incentives explains not only variation in misreporting across firms, but also time- series variation in misreporting within a firm.

Our results suggest a more nuanced view of equity incentives as they relate to misreporting. By explicitly considering the role of risk-taking incentives on the decision to misreport, and simultaneously estimating the incentive effects of portfolio delta and vega, our results potentially reconcile the conflicting evidence reported in prior studies that focus exclusively on portfolio delta. The results suggest that equity portfolios provide managers with incentives to misreport not because they tie the manager’s wealth to equity value, but because they tie the manager’s wealth to equity risk.

The full paper is available for download here.

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