Connecting the Dots
New research sheds light on connection between generous CEO stock options and elevated accounting statements
In his 2002 U.S. Senate testimony, Federal Reserve Chairman Alan Greenspan linked recent accounting problems to poorly structured option contracts that "perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and rising."
Accounting Professor Edward Swanson provides what he believes is the first empirical evidence strongly linking CEO stock options with an increase in the likelihood of an accounting misstatement and a subsequent restatement.
In a working paper, Swanson and accounting PhD candidates Anup Srivastava and Jap Efendi investigate the incentives that led to the rash of accounting restatements at the end of the 1990s. Comparing companies that announced a restatement in 2000 or 2001 to matched control firms, they find the likelihood of a restatement greatly increases when the CEO has a sizable amount of stock options "in-the-money" (i.e., stock price above exercise price).
While less influential than in-the-money options, Swanson and co-authors find the likelihood of a restatement to be "significantly higher" for firms that make one or more sizable acquisitions or are constrained by a debt covenant based on interest coverage. Weaker corporate governance is also significant. Firms are more likely to restate if they combine the CEO and board chairman positions or give the CEO a salary increase that is not warranted by the firm's performance.
"What our study shows is that, when executives have a very sizeable amount of options that are in-the-money, then their incentive to keep the stock price where it is, or higher, becomes so strong they can be corrupted. They seem to count that money as their own," Swanson says.
According to Swanson, CEOs who cashed in their stock options and then restated did not cash in fully. They left lots of money on the table, which they lost in the restatement. He explains a possible reason is that investors closely monitor CEO trading. And the chief officers wanted to avoid added scrutiny of the financial statements.
Swanson and co-authors are readying the paper for future journal publication. Because the findings shed new light on the issue, the research has already drawn national and international attention. In fact, Business Week Online penned an article, "Options Today, Restatement Tomorrow?" in May based on the research.
"One of the representative congressional committees called to ask if they could distribute the paper in Congress when debating stock options," he says. "This paper has been almost career refreshing in that it has had so much interest from the real world." @
By Alycia C. Zuehlke
