Why do firms issue financial misstatements?

“…. Srivastava and his colleagues found that the best predictors of accounting misstatements turned out to be in-the-money values of stock options held by CEOs.”

Introduction (Ed Swanson @ Kellogg)

When the dot-com bubble of the late 1990s sent stock prices soaring, something else soared, too: CEOs’ perceptions of their net wealth. That theory alone may explain a large part of the psychology and behavior of why some corporate managers allowed their accounting books to get cooked.

On March 10, 2000, the dot-com bubble burst abruptly and as a result many firms had to issue accounting restatements well into the next decade. Let’s face it, a lot of people lost a lot of money, and not just the CEOs who watched large portions of their own stock holdings in their own companies vaporize. Let’s also not forget the chasm of broken trust that opened between the business community and the public.

So what happened? Did the CEOs transmogrify into greed-poisoned crooks? That answer may satisfy our human desire for a villain, but that is not exactly how things played out, says Anup Srivastava, an assistant professor of accounting information and management at the Kellogg School of Management.

Great Excerpts (Via Ed Swanson @ Kellogg)

Srivastava says that an important trend in CEO compensation over the past two decades has been an increasing emphasis placed on company stock options. When this collides with market overvaluation, CEOs may find that their in-the-money stock options balloon into the stratosphere to nearly one hundred times the value of their salary.

“Let’s say their in-the-money stock options are worth a billion dollars now,” Srivastava says. “They may start to think, ‘I’m a billionaire.’” By confusing their overinflated stock options with their net wealth, these CEOs begin to make riskier and riskier decisions, perhaps to preserve their perceived wealth. It is a fragile zone to live within; a 10 percent decline in their company’s stock price could spell out a 50 percent decline in their net wealth.

“In this scenario, they will do anything and everything to keep the stock values high,” Srivastava says. But this motivation may also extend beyond their own personal gain; they may want to maintain the status quo by not liquidating their holdings as to avoid attention from the Securities and Exchange Commission or their investors regarding the overvaluation problem.

Important Findings for All Investors (via Ed Swanson @ Kelogg)

By doing this, Srivastava and his colleagues found that the best predictors of accounting misstatements turned out to be in-the-money values of stock options held by CEOs.
The biggest take-home message that Srivastava and his team found is that if a CEO holds very large in-the-money stock options, achieved largely because of overvaluation in his or her firm’s equity, then that firm is at a greater risk of fraudulent accounting. This risk increases dramatically once the CEO’s ratio of in-the-money-options to salary base crosses above the eightieth percentile of comparable firms.

So what does all this boil down to for a board committee that structures compensation? “If the stakes are extra high, just be cautious,” Srivastava advises. “Of course, it helps if the CEO is not also the board chair.”

Click Here To Read: Motivations For CEO’s To Cook the Books–Cooking the Books- Why do firms issue financial misstatements?

About Miguel Barbosa

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18. February 2011 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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