ACCTG 502 | Session 1 | The Relation Between Equity Incentives and Misreporting - 2005

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

Introduction:

Previous research indicates that a manager with wealth more sensitive to changes in the firm's stock price has a greater motivation to misreport. However, if the manager is risk-averse and misreporting increases both equity values and equity risk, then the sensitivity of the manager's wealth to stock price changes (portfolio delta) will produce two opposite incentive effects: a positive 'reward effect' and a negative 'risk effect.' Conversely, the sensitivity of the manager's wealth to changes in risk (portfolio vega) will have a clearly positive incentive effect. We demonstrate that considering both the incentive effects of portfolio delta and portfolio vega together significantly alters the conclusions of previous studies. Using both regression and matching approaches, and measuring misreporting through discretionary accruals, restatements, and enforcement actions, we find strong evidence of a positive relationship between vega and misreporting, and that the incentives from vega include those of delta. Overall, our results suggest that equity portfolios encourage managers to misreport when they make managers less risk-averse about equity risk.