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Is Your Company Safe? The Link Between Stock Options and Accounting Fraud | Bloomberg BNA

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The sun always rises. Time is unidirectional. Financial wealth can beget greed. All are fundamental truths of the universe. With regard to the last, is it possible to theorize on the link between performance-based corporate executive compensation and accounting fraud? How do we determine what separates Chief Executive Officers (CEO) such as Jeffery Skilling and Kenneth Lay from the failed conglomerate Enron from perceived highly successful CEO’s such as Jack Welch at General Electric? All of the former corporate executives were handsomely compensated in company stock options, so is it really possible to derive a correlation between corporate pay metrics and fraud? We dive deeper for answers.

Stock Options Rising as a Percentage of Total Pay

A 2014 Harvard University study concluded that the average CEO compensation makeup for a Standard & Poor’s 500 company was comprised of 57.2 percent stock award and options. This statistic asserts that the average S&P 500 corporation compensates its CEO primarily through a channel directly associated with the company’s financial performance. The same study concluded that only 11.6 percent of the median compensation package for a CEO of an S&P 500 company was through his or her base salary.

 

Linking Empirical Evidence

In 2007, Jared Harris and Philip Bromiley, professors at Darden and Merage business schools respectively, conducted a study on the link between option based executive compensation and financial misrepresentation. Using data from the then General Accounting Office (GAO), the professors analyzed 919 restatements by 845 firms from January 1997 through June 2002. They concluded that the average restatement percentage over a five year period was 8.8 percent. When the compensation for a CEO (often a metric for other executive pay) is more than 92 percent option-based that number jumps to a 21 percent chance of restatement in a five year window. The most dramatic increase comes when

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