Feb 2, 2011

Cook­ing the Books

Why do firms issue finan­cial misstatements?

Based on the research of

Jap Efendi

Anup Srivastava

Edward P. Swanson

Listening: Interview with Anup Srivastava


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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.

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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.

While most firms were not guilty of account­ing irreg­u­lar­i­ties or crim­i­nal activ­i­ty, a few were. Sri­vas­ta­va and Jap Efen­di, an assis­tant pro­fes­sor at Uni­ver­si­ty of Texas at Arling­ton, and Edward P. Swan­son, a pro­fes­sor at Texas A&M, dug into the prob­lem of over­val­u­a­tion of firms’ equi­ty, and they devel­oped sev­er­al rea­sons why CEOs may have over­seen the release of false or mis­lead­ing finan­cial state­ments. At the heart of the mat­ter was a con­flu­ence of CEO com­pen­sa­tion struc­tur­ing with a lit­tle idea (hold­ing large impli­ca­tions) about how very large incen­tives can cause nor­mal­ly law-abid­ing cit­i­zens to step out­side the law’s bounds.

Tak­ing Risks
Sri­vas­ta­va explains that in 2005, Har­vard pro­fes­sor emer­i­tus and not­ed finan­cial econ­o­mist Michael C. Jensen wrote a paper titled Agency costs of over­val­ued equi­ty,” which was pub­lished in the jour­nal Finan­cial Man­age­ment. In this paper, Jensen argues that man­agers are nor­mal human beings but when the stakes are very high, nor­mal human beings begin mak­ing extreme­ly risky deci­sions,” Sri­vas­ta­va says. Our paper exam­in­ing the over­val­u­a­tion of a firm’s equi­ty dur­ing the dot-com years is the only paper that has test­ed his theory.”

When Sri­vas­ta­va says a firm is over­val­ued, he is refer­ring to extreme sit­u­a­tions where the stock may be worth 100 to 1,000 per­cent of its fun­da­men­tal val­ue. When this hap­pens, the firm’s fun­da­men­tals can­not jus­ti­fy the stock price and so man­agers begin to do things.”

They start tak­ing extreme risks. They make acqui­si­tions and play with their account­ing num­bers,” Sri­vas­ta­va explains. This is very destruc­tive to soci­ety. Deci­sions based on over­val­ued equi­ty are not good for soci­ety because they lead to a loss of wealth.”

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.

Deci­sions based on over­val­ued equi­ty are not good for soci­ety because they lead to a loss of wealth.”

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.

What we high­light in our paper is the fact that when equi­ty is over­val­ued, and over­val­u­a­tion in equi­ty results in large in-the-mon­ey options for man­agers, then man­agers have incen­tives to take very risky account­ing deci­sions,” Sri­vas­ta­va says.

Show Me the Mon­ey
The researchers used nine­ty-five sam­ple firms — pin­point­ed from a Gov­ern­ment Account­abil­i­ty Office (GAO) data­base of com­pa­nies that restat­ed a pre­vi­ous­ly issued finan­cial state­ment — and com­pared these to nine­ty-five con­trol firms that had not issued restate­ments but were matched in terms of size, indus­try, and asset values. 

They then exam­ined the firms that announced a restate­ment between Jan­u­ary 1, 2001, and June 30, 2002, for account­ing errors in pri­or years, extend­ing back to April 1995. (Firms often announce a restate­ment one to two years after the year being restat­ed, e.g., a restate­ment announced in Jan­u­ary 2001 could be for the account­ing year 1999 or 2000.) The team used press releas­es and annu­al reports to dis­cov­er the exact year of the mis­state­ment, a detail the GAO data­base lacks.

For exam­ple, say an Inter­net com­pa­ny called Wid­get­Techs tanked in the 2000 bust and announced a restate­ment of its accounts lat­er. Sri­vas­ta­va and his team basi­cal­ly poked through records to find Wid­get­Techs’ his­toric stock prices and its com­pen­sa­tion pack­age. Then they dis­sect­ed this data to look for trends that asso­ci­at­ed aspects of com­pen­sa­tion to time points right before, dur­ing, and after account­ing irreg­u­lar­i­ties, or crim­i­nal activ­i­ty, was said to have occurred.

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. To illu­mi­nate the mag­ni­tude of in-the-mon­ey option hold­ings, they found the aver­age hold­ings for CEOs at restat­ing firms was approx­i­mate­ly $50 mil­lion, which great­ly exceed­ed the aver­age of $9 mil­lion at matched firms that did not announce a restate­ment. Stat­ed anoth­er way, the CEOs of restat­ing firms held options with in-the-mon­ey val­ue that was forty-six times their salary, com­pared with options six times the salary of CEOs in con­trol firms.

The team then parsed the restat­ing firms into two main cat­e­gories based on account­ing issue clas­si­fi­ca­tions assigned by the GAO — non-malfea­sance and malfea­sance — that describe the degree of seri­ous­ness of the firm’s account­ing error. (A malfea­sance cat­e­go­ry cor­re­lates to fraud­u­lent behav­ior or an SEC-induced restate­ment, while a non-malfea­sance cat­e­go­ry cor­re­lates to a non-crim­i­nal, less seri­ous issue or irregularity.)

The researchers found that the in-the-mon­ey val­ue of options for CEOs at restat­ing firms with evi­dence of account­ing malfea­sance was even high­er, aver­ag­ing approx­i­mate­ly $130 mil­lion (com­pared to an aver­age of $50 mil­lion for all restat­ing firms).

One of the study’s key insights cen­tered on the degree to which options were in-the-mon­ey. The analy­sis detect­ed no dif­fer­ence between the val­ue or num­ber of options issued by restate­ment and con­trol firms to their CEOs. In oth­er words, the larg­er in-the-mon­ey val­ues of restate­ment firms were not due to the num­ber of options held but the degree to which the firm’s stock options were in-the-money. 

With­in both the restat­ing firms and the con­trol firms, the research team ana­lyzed CEO com­pen­sa­tion to look for pre­dic­tors that a firm would issue a restate­ment. They test­ed the base salary, bonus, options grant, in-the-mon­ey stock options, restrict­ed stock grants, and restrict­ed stock hold­ings. The only sta­tis­ti­cal­ly sig­nif­i­cant vari­able turned out to be in-the-mon­ey options.

Sri­vas­ta­va and his col­leagues scru­ti­nized this fur­ther to esti­mate the thresh­olds of in-the-mon­ey options where the prob­a­bil­i­ty that a firm would issue a restate­ment lat­er increased sig­nif­i­cant­ly. Again, using Wid­get­Techs as an exam­ple, imag­ine that its CEO’s in-the-mon­ey options in 1999 were twen­ty-one times the val­ue of his or her base salary. When ranked against the oth­er firms in the study, this would place the firm in the eight­i­eth per­centile — smack in the dan­ger zone, where any increase in in-the-mon­ey val­ue would dra­mat­i­cal­ly increase the prob­a­bil­i­ty that the firm will have to issue a restatement. 

If the in-the-mon­ey options to salary ratio had land­ed in the nineti­eth per­centile — where in-the-mon­ey options were fifty-three times the salary val­ue — then Wid­get­Techs would be 43 per­cent more like­ly to issue a restate­ment. If that ratio had risen fur­ther to the nine­ty-fifth per­centile — where in-the-mon­ey options were a whop­ping 136 times the salary val­ue — then the restate­ment prob­a­bil­i­ty leaps to 56 percent.

Fig­ure 1. Increase in restate­ment prob­a­bil­i­ty as the val­ue of CEO in-the-mon­ey options increase

The point is that when things go extreme, then the prob­a­bil­i­ty jumps up,” Sri­vas­ta­va sum­ma­rizes. But some peo­ple refut­ed that in-the-mon­ey options val­ue could bal­loon as high as 136 times salary. Review­ers of the paper want­ed con­crete exam­ples. Nor­mal­ly in our research, we nev­er name firms,” Sri­vas­ta­va says. But we had to give a table with the firms and the val­ue of their CEOs’ in-the-mon­ey stock options because peo­ple dis­be­lieved us that it could be so high.”

Lead­ing their list was JDS Uniphase, whose CEO held $1,278,017,054 in in-the-mon­ey stock options. Yes, that’s $1.28 bil­lion. Com­ing in sec­ond was Freemar­kets, whose in-the-mon­ey stock options totaled $751,140,000.

A Crys­tal-Clear Pat­tern
Per­haps the most con­vinc­ing part of this research is appar­ent in a table that fol­lows the move­ment of CEOs’ in-the-mon­ey options ratio to salary across time for both the sam­ple and con­trol firms. The researchers pin­point­ed the years when fraud­u­lent activ­i­ty or account­ing irreg­u­lar­i­ties actu­al­ly occurred, then looked at the firms’ mar­ket val­ues and the val­ue of the CEOs’ in-the-mon­ey options in the pre­ced­ing year to fig­ure out what, if any­thing, the CEOs might have been moti­vat­ed to pro­tect in accor­dance with Jensen’s the­o­ry of over­val­ued equity.

Remem­ber, the time­line of events was as fol­lows: over­val­ued equi­ty result­ed in large in-the-mon­ey options for CEOs, man­agers then mis­stat­ed accounts in an effort to keep stock prices high, and then account­ing impro­pri­eties were admit­ted a few years lat­er via announce­ments of an account­ing restate­ment. In this sce­nario, the rel­e­vant point at which incen­tives could have led to irreg­u­lar­i­ties was the year imme­di­ate­ly before the mis­stat­ed year. If the equi­ty or in-the-mon­ey val­ue was real­ly over­val­ued, those val­ues should have declined from that point onwards.

Sri­vas­ta­va and his col­leagues test­ed the same data at three time points in addi­tion to the point imme­di­ate­ly before the mis­stat­ed year: the end of the year when the anom­alies occurred, the end of the year when a restate­ment was announced, and one year after the year in which the restate­ment was announced. What emerged was a crys­tal-clear pat­tern in both the malfea­sance and non-malfea­sance cat­e­go­rized firms where CEOs’ ratio of in-the-mon­ey stock options to salary declined dra­mat­i­cal­ly over time, like a bal­loon deflat­ing, from 46.2 times to 25.4 times to 15.3 times to 10.8 times.

This table clear­ly demon­strates some­thing was over­val­ued and it was cor­rect­ed over time,” Sri­vas­ta­va explains. We’re talk­ing very big num­bers here.”

Big indeed. Firms that were guilty of account­ing malfea­sance found their CEOs’ options-to-salary ratio declin­ing from an aver­age high of 99 to 12.7 over that peri­od, halv­ing near­ly every year. That is, their in-the-mon­ey options were 99 times the val­ue of their salary, declin­ing to 12.7 times the val­ue of their salary over time. 

Firms with account­ing irreg­u­lar­i­ties but no malfea­sance saw their CEOs’ ratio decline less steeply from an aver­age of 22.9 to 9.9. Clear­ly, the mar­ket had over­val­ued the equi­ty of these firms. Astute observers might rea­son that this decline occurred because CEOs liq­ui­dat­ed their stock options and cashed out on a large scale. But the researchers ruled this out and deter­mined that CEOs did not exer­cise their options in time. It is pos­si­ble that CEOs left much of this poten­tial wealth on the table when the mar­ket bub­ble burst,” Sri­vas­ta­va suggests.

The team also found that the mar­ket-adjust­ed val­ue of the top-ten firms, ranked by the largest in-the-mon­ey options to salary ratios, fell near­ly 11 per­cent in the five days after their announce­ment of a restate­ment. This is com­pared to a 4 per­cent aver­age fall for the restat­ing firms that had less seri­ous account­ing prob­lems. Firms guilty of malfea­sance expe­ri­enced mar­ket-adjust­ed val­ue dips of 7.2 per­cent, com­pared to near­ly half that rate for the restat­ing firms not guilty of malfeasance.

All of this shows us that if you think that in-the-mon­ey options led to crim­i­nal behav­ior, and the crim­i­nal behav­ior is mea­sured by the extent of malfea­sance in the account­ing re-state­ment, we find evi­dence con­sis­tent with that,” Sri­vas­ta­va concludes.

Lessons Learned
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.”

Relat­ed read­ing on Kel­logg Insight

Sus­pi­cious­ly Short: CEOs with stock options may pur­pose­ly miss earn­ings targets

When Exec­u­tives Sell: The influ­ence of wealth diver­si­fi­ca­tion on con­tract­ing schemes

Featured Faculty

Anup Srivastava

Member of the Department of Accounting Information & Management faculty from 2008 to 2014.

About the Writer

T. DeLene Beeland is a science writer based in Graham, NC.

About the Research

Efendi, Jap, Anup Srivastava, and Edward P. Swanson. 2007. Why do corporate managers misstate financial statements? The role of in-the-money options and other incentives. Journal of Financial Economics. 85(3): 667-708.

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