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Accounting Research Center Booth School of Business University of Chicago
Is There a Link between Executive Equity Incentives and Accounting Fraud?Author(s): Merle Erickson, Michelle Hanlon and Edward L. MaydewSource: Journal of Accounting Research, Vol. 44, No. 1 (Mar., 2006), pp. 113-143Published by: on behalf ofWiley Accounting Research Center, Booth School of Business,University of ChicagoStable URL: http://www.jstor.org/stable/3542319Accessed: 22-03-2016 04:24 UTC
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DO 101111/1475679X200600194x
Journa ofAccountngReearch
V o 44No1 M arc h 2006
P rn te dn U S A
Therea LnkbetweenExecutve
Equty ncentve andAccountng
Fraud?
MERLEERCKSON* MCHELLEHANLONtAND
EDWARDL MAYDEWt
Receved8Apr 2004accepted3 Augut2005
ABSTRACT
Wecompareexecutveequtyncentve offrm accuedofaccountng
fraudbytheSecurte andExchangeComm onSEC durngtheperod
19962003w t h t wo amp e of f rm n ot a cc u e d of f rau dWe me au re e qu t y
n c en t v e n av are t y ofw ay an d e mpoy ab at t ery of e mprc a t e t We f n dn o
con tentevdencethatexecutveequty ncentve area ocatedwthfraud
Th e e re u t t and n c ont ra t t o a e rt on byp o c ymak er t hat n c e nt v e
fromtockba edcompenaton andthereut ngequtyhod ng ncreae the
ke hoodofaccountngfraud
1 ntroducton
S ome of t h e arg e t a cc oun t n gf rau d n h t ory o c cu rre dn t h e a t e v
e ray e ar e adng t o t h e w e k n ow n uph eav a n t h e a cc oun t n gn du t ry
*U n ve rt y of C h c ago t U n v e rt y of M c h g an t U n v er t y of Nort h C aron a We h ave
beneftedfromcomment fromRayBa edtor RobertBuhman aDchev ArthurKraft
M ark L an g Sh v aRag opaJoh n Robn on S t e ve Ro c k Ph Sh an e Te rry Sh e vn Joe S e mrod
w ork h opp art c p an t a t L ond on B un e S c hoo M c h g an S ta t e U n ve rt y U C B erk e ey
U CLA t h e U n v er t y of C oorad o t h e U n ve rt y of F ord a t h e Un v e rt y of North C aron a
t h e Un v e rt y of Oreg on t h e U n ve rt y of Te x a a t Au t n an dWah n gt on Un v e rt y an d
ananonymou refereeJudon Cakey ScottDyrengandBradLnd eyprovdedvauabe
reearcha tanceWeapprecatefundngfromtheUnver tyofChcagoGraduateSchooof
Bu n e t h e Ro S c hooof B u n e a t t he U n v e rt y of M c h g an and an E rn t &Y oungF ac u ty
F e ow h p an d t he U n v e rt y of Nort h C aron aKe n an F ag e rB u n e S c hoo re p e ct v e y
113
Copyrght?Unver tyofChcagoonbehafof then ttuteofProfe onaAccountng2006
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114MERC KSON MHANLON AND EL MAYD EW
an dw e epn g e g at v e and re gu at ory c h ang e Th e e e v en t h av e e f t e g
a t or re gu at or p rac t t on er an d acad emc e arc h n gf orc au e of t he e
fraud Undertandngtheunderyngforcethatgaver etothee fraud
anece aryprecurortoeffectvey preventngfutureoccurrence Many
haveuggetedthattheexpanaton e nthe ncentve andopportunte
forperonaga nfacedbyexecutve
On e of t h e n c en t v e t h at man age rm gh t b e re p on dn g t o t h e n c re a e
ntheproportonoftherweaththat tedto tockbaedcompenaton
an d t h e re u t n g e q u tyh odn g t w e d o cumen t ed t h at th e u e of t o ck
opton a aformofexecutvecompenatonro edramatcay durngthe
1990 a d d o t h erf ormof p ay f orp erf orman c e p an u c h ag ran t of
re t rc te d t o c k andb on u p an t e d t op e rf ormanc e Murph y1999 A
ubtanta bodyoftheoretca workbegnnngw thJenenandMeckng
1976 h ow t h at th e e p an c an b e u e fu n a gn n g t he n ce n t ve of
manag er w t h t h o e of h are hod e r F oow n g t h w ork many e mpr
care earcher havepredcatedtheranay e onthepreme thatgrantng
op t on c on t en t w t h f rmv au e maxmzat on f ore x amp e e e D em
e t zandL e hn 1985 Hmme b ergH ubbard an dP a a 1999 C ore an d
Gu ay 1999 an dRagop a an d She vn 2002 M ore ove ra n umberof
e mprc ap ap er f n d re u t c on t en t w t h t he n c e n t ve a gn me nt v e w
F ore xamp e B rc k e yB h agat an dL e a e 1985re p ort p o t v e t o c k p rc e
reacton toannouncement ofong termmanagera compenatonp an
An ot h ere x amp e L e we e n L ode rer an dRoe nf e d 1985 w h of n d e v
d e nc e c on t e nt w t h man ag e rb e n g e k e y t omake me rg e rbd t h at
ow ert h e r t o ck p rc e w he n t he yh odmore t o ck n t h e f rmc on t e nt
w t h t h e rn t ere t b e n g agn e dw t h h areh od er Th ere e v en ome
emprca evdencethat onaverage executve tockoptonare effectve
ngeneratngpo tvefuturepayoff forthefrm nterm ofaccountng
e arn n g H an on Rag opa an d She vn 2003
Howeverthereareother thatvewoptoncompenatondfferenty
Somearguethatoptonare anneffcentwaytocompenatemanager
(Jenter [2001], Meulbroek [2001], and Hall and Murphy [2002]), that
manager ue optongrantforther ownbeneft AboodyandKa znk
2000Y e rmac k 1997 ort h at t o ck op t on d on o t e xh b t e mpr
c are a t on c on t e nt w t h t h e e con omc mot v at on b e h n dgran t ng
themYermack 1995 Further recentworkbyBebchukFr edand
Waker2002 arguethatexecutve havethepowerto nfuencetherown
paythatexecutveu ethatpowertoextractrent andthattherde re
tocamoufagether rentextractonmght eadtotheue ofneffcent
payarrangement thatprovdeuboptma ncentve therebyreducng
1 n add t on n a t u dy of n e w e con omyf rm t t ne rL arc ke ran dL ambe rt 2003f n d t h at
owerthanexpected tockoptongrantand/orext ngoptonhod ng area ocatedwth
oweraccountngandtockprce performancen ubequentyear Howevertheyfnd tte
con tenta ocatonbetweenfutureperformanceandgreaterthanexpectedoptongrant
andhodng
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD115
h are h ode rv au e n re a t edw ork B arG an dB eb c huk 2003an d
GodmanandSezak 2006mode managera ncentve toreporttruth
fu yand howthatperformancebaedcompenatoncan nducemanager
tom reportperformanceJenen2003 a ertthatnon neartyn payfor
p e rf ormanc e y t e m n duc e man age rt o e an d t hat u c h y n g op e rva
vethatfrm woudbebetteroffadoptngo ey nearpayforperformance
ytem
Gventhencreaedu eofperformancebaed compenaton overtme
and t h e t he ore t c a an d e mprc a argumen t of t h ort c omn g t p o
bethatthepercevedncreae ncorporatefraudn theate1990 andeary
2000 wa apredctabeoutcomeoftheechanged ncentve ndeed th
concuon eemto havebecomeacceptedw domamongpocymaker
andreguator ForexampeA anGreenpanCharmanoftheFederaRe
e rve B o ard n h e mann u amone t aryp o c y re p ort t oC on gre on Juy
162002 p e cu a t ed ab out t h e c au e of t he a c cou nt n gf rau d a f o ow
An n f e ct ou g ree d e e med t og rpmu c h of ourbu n e c ommun ty
Toomanycorporateexecutve oughtway to harvet omeofthoe
to c k mark et g an A are u t t h e h gh yd e rab e p read of h are hod
ngandopton amongbune manager perverey createdncentve
t o art f c ay n f ate re p ort ed e arn ng n ord ert ok e ep t o ck p rc e h gh
an d r n gTh ou tc ome u gge t t h at t h e opt on w ere p oory t ruc t ure d
an d c on e qu e nt y t h ey f ae d t op rop ery a gn t he on g t e rmn t ere t of
harehoder andmanager theparadgmo e enta foreffectvecorpo
rategovernance Thencentvetheycreatedovercamethegood udgment
oftoomanycorporatemanager t notthathuman havebecomeany
more g re edy t han n g e n e ra t on n t h e p at t t hat t h e av e nu e t o e x p re
greedhadgrowno enormou y
Furtherevdence found nproecutor argument nthee fnanca
accountngfraudcae Forexampe ntheBerneEbberca e theformer
CEOofWordCom theproecutonarguedthatEbberwa motvatedto
commtfraudwhentheendofawaveofmerger andthebegnnngof
ametdownn theteecomndutryputpre ureonthecompany hare
p rc e Th e y argu ed t h at E b be r p e rona f ort une w a arge yb ae d on
WordComh are an dh e had b orrowe dn eary $ 400m on w t h t ho e
h are a c o a t e ra A c kman 2005 E bbe rman t an e d t hat h e c ommt
tedthefraudtokeepupwthWa Streetexpectaton andnotforperona
g an h e h e dh h are unt WordComf e d f orb an kru pt c yn Juy2002
threemonth afterhewa forcedtore gnandonemonthafterthefraud
w aun c ove redA c k man 2005 Sm ara e g at on ab ou t t he n k b et w ee n
f rau d an d e xe c ut v e t o c k op t on w ere made n o t he rc a e e g H e a th
ou th Th e purp o e of t h p ape r t o e x amn e w h et h ert h e e mprc a e v
d e nc e u pp ort t he c am t h at e q u t yn c en t v e re u t n gf romt o c k b ae d
compenaton arepo tvey a ocatedwththeprobab tyofaccountng
fraud
We b egn by d e nt f yn g a f rm e xp c t y ac c u e d of a cc oun t n gf rau d
bytheSecurte andExchangeComm onSEC durngtheperod
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116MERC KSON MHANLON AND EL MAY D EW
January 1996 to November 2003. Using actual SE C allegations of fraud
v od b ae t h at c an o cc u rw he n a amp e e e c te d b a e d on re e arc h er
nterpretaton aboutwhchaccountngprobem arethereut offraudand
w h c h are n o t Af te rome re t rc t on n c u dn g th e av a ab t y of e xe c ut v e
c omp e n at on d at aou ramp e c on t of 50f rm ac cu e d of a c count n g
fraudbytheSECdurngth perod hereafter the fraudfrm or fraud
amp e We c omp are t h e f rau d f rmw t h t w o amp e of f rm n ot a cc u e d
of f rau dF r t w e c omp are t he f raud f rm w t h amat ch e d amp e of f rm
hereafter the matched ampe nwhchwe eecttwomatchedfrm
n ot a cc u e d of f rau db ae d on ze y e aran dn du t ry f ore a ch f raud f rm
Second wecomparethefraudfrm wthanunmatched ampeoff rm
c on t n g of a re man n gf rmye ar me an n g a f rmye aro t h ert h an
thoeof the50fraudfrm onExecuComphereafterthe unmatched
ampe
Weet mateavaretyofequty ncentvemeaure forthetopfveexecu
t v e a t e a c h f rmf oc un g p e c f c ay on t h e e xp e ct e d c han ge n v au e of
theexecutve tockandoptonportfo otoa 1% tockprcechange here
after en tvty n unvarateandmutvarateana ye forthematched
amp e w e f n dn o gn f c ant a o c a t on b et w ee n f rau d an d th e e n t v
t y of e qu t yh odn g n t h e unmatc h ed amp e u n g og t c re g re on
w e f n d gn f c ant a o c a t on b e t we e n fraud an d e n t v t yw h en w e
n c u d e n o c on t ro v arab e n t h e reg re on H ow ev e rt h e e a o c a
ton become n gnfcantwhenwencudecontro forcorporategover
nance thedere forexternaf nancngfnanca performance andfrm
ze
naddtona anaye weexamnewhetherthere evdencethatexecu
t v e a t f rmac c u e d of f rau dy t e mat c ay e t o ck an d e xe rc e op t on
durngtheperodofthea egedfraudtoa greaterextentthanexecutve
nthematchedandunmatched ampe ofcontro frm Wedonotfnd
gn f c ant ygre a te rt o c k a e orop t on ex e rc e by e x ec u t ve a t f rau d
frm comparedtononfraudfrm regarde ofwhetherthecomparon
baedon thematchedampe ortheunmatchedampe
S ome c ave a t are n orde rWh e ou ramp e of f raud f rm b ae d on SEC
a e g at on of f rau d an d t he ref ore f re e of re e arch erc a f c a t on b a
there noperfectmethodof dentfyngfrm thatengagen accountng
f rau dWh at ourt e t re y on t hat t h e probab t y t hat af rme n g ag e dn
f rau d g rea t erf orf rm ac cu e d of f rau dby t he S E C t han t f orf rmn ot
accuedbytheSEC
Ne ve rth e e an y c a f c a t on of f rm n tof raud an dn onf rau d c a te
g ore w n e v taby c ont an b o th Typ e an dTyp e e rror f w e a ume
th at th e Type e rror re a t v e yma n f rm ac cu e d of f raudby t h e S EC
re a t ve t o o t he ramp e e e c t on me t hod e g ze of d c ret on ary ac
c rua t h en ou rt e t are b e t n t e rp ret e d a on t t e t of t he k e h ood
of e ng agn gn f raud an db e n g c au ght by t h e S EC t un k e y h owe v er
thattheSECcatchea fraudandthu theampe contan anunknown
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD117
amount of Typ e e rror2Wh e n an d e a w ordw e w ou dh av e ap e rf e ct
amp e w e mpy c ann o t re abyd e n t f y f rmt h at c ommt f rau d an dg et
awaywth t Oneapectofthepotentaundercountngoffraud thatt
coud nducea eemnga ocatonbetweencompenatonandfraudeven
f n one e x t ed Th c ou d o cc u rf t h e S E C more k e y t on v e t g a t e
o rn v e t g a t e w t h more c ru t ny ac count n gp rob e m t h at o c cu rn f rm
t hat p ayh gh e v e of t o c k b ae d c omp e n at on t o t h e re xe c ut v e n t h at
c a e t he S E C ow n e e c t on c rt era c ou d n duc e an a o c a t on b et w ee n
compenatonandSEC nvetgaton and/ora egatonof fraud
Th e p ap e rp ro c ee d a f o ow n e c t on 2w e d c u p rorre a t ed t er
a t ure n e c t on 3w e d c u t h e amp e e e c t on S e c t on 4c ont an t h e
re u t an d e c t on 5c onc u d e
2 ProrRe earchontheDetermnantofFraudandReated ue
Wh e t h e e t of p ap e rt h at ex amn e ac c oun t ngf raud ma n n umbe r
thebroadercontextofth tudyreateto compenatonandf nancare
p ort n gn c e nt v e F ore xamp e Ke d a 2003 C h en g an dWarf e d 2005
Ke 2002 andGaoandShreve 2002examnethereat onbetween
compenatonandearnng managementmeaure eg d cretonaryac
c rua e arn n g t h at u t me e t orb ea t an ay t f ore c a t ma p o t v e e arn
n g an n oun c eme nt e t c Rc h ard on Tun aan dWu2003an dE f en d
Srvatav andSwanon2004 examnethereatonbetweencompenaton
an d re t at eme nt an dD en H anouna an d S arn 2005 e x amn e t h e re
a t on b et w ee n c omp en at on an d c a a c t on aw u t Ou rt u dyfo c u e
on f rmac c u e d of n t en t ona y f rau du e n t ym t at ng e arn ng Wh e
earnngmanagementre tatement andfraudharecertantrat andare
a phenomenaworthyof tudytheyarenotthe ameFraudandearnng
managementdffer nthatearnng managementcanbew thnorout de
ofgenera yacceptedaccountngprncp e GAAP wherea a egedfraud
u e nt a c c ou n t ng n v araby ou t d e of GAAPn add t on ac c ru a mode
areuefu npartbecauetheycanbeapp edtotheentremarketbutare
u b e ct t ow e k now n m t at on e e D ec h ow S o an an d Swe en e y 1995
Gu ay Koth ar an dWat t 1996 an dH eay an dWah e n 1999 F rau d an d
re t a te men t d f f e rn t h at re t a te men t d on o t n e ce ary re f ec t ap rorn
tenttodecevewhereafraudbydefnt onnvove ntenttodeceve For
exampePa mroeandSchoz 2002examne492re tatementandf nd
thatony11%reu t nanAccountngandAudtngEnforcementReea e
AAER u e d agan t t h e f rman d on y 38% re u t n t g at on Th
con tentwthretatement refectngawde varetyofbehavorrangng
fromgenunedagreement overtheappcatonofGAAPto pecfc et
2 Although one could argue that very large magnitude frauds are more difficult for managers
t oh d e n d e f n t e y an d t h u t h ere w ou db e e m c a f c a t on of fraud n v ovn g arg e
magntude
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118MERC KSON MHANLON AND EL MAYD EW
oftranacton conttutngfraudExamnng thepurportedcaue off
n anc a a c cou nt n gf rau d mport an t n t ow n rght a e v d en c ed by t h e
wdepread mpactofthefnancaaccountngfraudofrecentyear The
re man de rof ou rd c u on of t he t e ra t ure p e c f c ay f o c u e d on pap er
reatedtoaccountngfraud
We are aware of on y t wopu b h e dp ap e rt h at ex amne p o b e n k
betweenequtyncentveand fraudDechow Soan andSweeney1996
examnethecaue andconequence offrm ubecttoSECenforcement
ac t on du rng t h e y ear19821992Th ey f n d t h at f rm ub e ct t o e n
forcementactonaremore keytohaveboard ofdrectordomnated
bymanag eme nt aC EOw ho a oC h arman of t he B o ard aC EOw ho
a o t h e f rm f oun d er n o au d t c ommt te e an dn oou t d e b o c k hod e r
Wh e n o t t h e f oc u of t h e r t u dy D e ch ow S o an an d Sw ee ne y 1996 f n d
n o gn f c ant e v d e nc e t hat amp e f rm h ad e arn n gb ae d b on u p an
ort h at of f c er an dd rec t or made un u u a amoun t of t o ck ae d u rng
themanpuatonperod Sncetheendofthe ampeofDechowSoan
andSweeney1996 n1992 tockbaedcompenatonha cometodwarf
e arn n g b ae d b onu e a af ormof n c en t v e c omp en at on We e x t en d
theworkofDechowS oanandSweeney 1996by examnngtheeffect of
t o ck b ae d n c en t v e e g t he e n t v t y of t o c k opt on an d t o ck h e d
onthepropen tyofexecutveto engagen a egedfraud
B e ne h 1999 f n d t h at manag er of f rm ub e ct t oAAER are more
k e y t o e t h e rown t o ck du rn gp erod n w h c h t he e arn ng man
ag eme nt t ak ngp ac e t h an are manag er of c ont rof rm n c ont ra t t o
D ec h ow S o an an d Sw ee n ey 1996 B e ne h 1999 d o e n o t f n d e vd en c e
thatmanageraremotvatedto nfateearnng nadvanceofanequty
uancebythef rm3
Recenty anumberofworkngpaperanayz ngaccountngfraudand
executvecompenatonhaveappearedJohnon RyanandT an 2005
fndthatexecutve offrm accuedoffraudhavegreaterunretrctedtock
ncentve to ncreae tockprcethandoexecutve offrm notaccued
of f rau dH ow ev e ra t t h e ame t me an d c on t e nt w t h ou rre u t t h ey
reportthatthefraudfrm donothavegreater ncentve fromveted tock
op t on un v e t e d t o ck op t on orre t rc t ed t o ck 4P e n g andRoe 2003
3Anot he rt u dyB e a e y 1996 f n d t hat ou t d e d re c to rd e c rea e t h e p rob ab t y of
f rau d a d oh gh ert e nu re and ow ne rh pby ou t d e d re ct o r B e a e y 1996f n d t h at t he
preenceofanaudtcommtteeha noeffectontheprobab tyoffraudbutdoe notexamne
executvecompenaton
4Thereareanumberof ampeandde gndfference betweenourpaperandthatof
Joh n on Ry an an dTan 2005 n ad d t on f w e rank ou re qu t yn c e nt v e v arab e n e t he r
ofourtestvarabes sconsstentysgnf cantn boththematchedandunmatchedsampe
H owe v er t he ran k of un re t rc te d t o c k gn f c ant y a o c a te dw t h t he k e h ood of fraud
wth ap-vaueof0 06 nthematchedsampeandap-vaueof 002 ntheunmatchedsampe
con t e nt w t h t h e Joh n on Ry an an dTan 2005me d an re u t f ort h v arab e Th e un
rank e dv aue are n gn f c ant y re a t e d to t h e k e h ood of fraud h owe v er w t h pv au e of
0797and0 230n thematchedandunmatchedampe repectvey
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD119
fndthat ncentvepay ntheformofopton butnotretrcted tockor
b a e p ay n c re a e t he p robab t y of p rv at e e c u rt e t g a t on 5Wh e w e
cana ofnd areat onbetweenequtyncentve anda egedfraudunder
c ert an p e c f c a t on w e f n d t hat t h e re u t are n o t robu t t o a t e rn at ve
p e c f ca t on an dn c u on of c on t ro v arab e Th u w e c on c u de t h at
there nocon tentevdenceofa nkbetweenexecutveequty ncentve
andaccountng fraud
3S amp e S e e c t on an dD e c rp t on
To dentfyfrm accuedofaccountngfraudwe earchedSECAAER
fortheword fraud durngtheyear 19962003AAER are ummare
oftheSEC accountngbaed enforcementacton anddecrbetheSEC
n v e t g a t on of a e g ed v o a t on of ac count n gp rov on of t h e e c u rt e
aw We req u re AAERt o c on t an ae g a t on of f raud t ob e n c u d e dn
ou ramp e b e cau e AAERof t en n v ov e n onf rau du en t u e F e ro zP ark
an dP at en a1991 6
Tab e 1 ummarze ou r amp e e e c t on p roc ed u re F romt h e e t of
AAERdurng theperodJanuary1 1996toNovember19 2003we den
t f y 287n t an c e e x c u dn gre pe a t a cc u a t on n w h c h t he S E C u e t h e
word fraud WeexcudeAAERthatarenotreevanttothe ubectofth
n qu ry u c h a a e g ed f raudbybroke ran dd e a e r g ove rnme nt p e ron
n e orc h art ab e organ za t on We a ore q u re u f f c e nt d c ou re ab out
executvecompenaton tocomputeoure tmate ofexecutveweath en
tvtyto tockprcechange Wefr t ooktotheS&PExecuCompdatabae
ExecuComp Forthefrm wthoutExecuCompdata wheneverpo be
wehandcoectthenece arydatafromproxytatement f edwththeSEC
Th re u t n a amp e of 50f rmt h at are b ot h ac cu e d of f raudby t h e
SECandforwhch wehavecompenatondata
Tab e 1a op re e n t n f ormat on on t he t w oc omp ar on amp e u e d
n t h t u dyF rt w e c omp e a matc he d amp e of f rm n ot a cc u e d of
accountngfraudForeachofthe50f rm accuedofaccountngfraud
we eecttwomatchedfrm notaccuedofaccountngfraudmatchng
on n du t ry t w odg t S t and ard n du t raC a f c a t on SC c ode y e ar
an d f rm ze t o t a a e t Th u w e h av e 100mat c he d amp e f rm f or
t h e mat ch e d amp e t e t S e con dw e a o c ompare t he 50f rm ac cu e d
offraudwtha theremanngfrm yearon ExecuCompAfterempoyng
datarequrement creen theunmatched ampecontan 13033f rmyear
obervaton notncudng the50fraudfrmob ervaton
5 nrecenttheoretcawork GodmanandSezak 2006deveopan agencymode nwhch
tockbaedcompenaton adoubeedged word nducngmanager toexertproductve
effortbuta o nducngmanager todvertvauabe reourceto m repreentperformance
Sm ary B arG an dB eb c huk 2003mod e man ag e ra n ce n t ve t o c ommt f raud
6 For more detail on AAERs and the SEC s process in investigating firms, see Pincus, Holder,
an dM oc k 1988 F e ro zP ark an dP at e na 1991 an dD ec h ow S o an an d Sw ee ne y 1996
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120MERC KSON MHANLON AND EL MAY D EW
TABLE1
Decrpton ofSampeSeectonProcedure
Sampeoffrm accuedoffraud
TotaAccountngandAudt ngEnforcementReeae AAER uedfrom287
January1 1996throughNovember19 2003attrbutabeto a egedaccountng
fraud nondupcate
Le
F rau d ae g a t on n o t ag an t af rm ort e x ec u t ve e g a e g at on 57
n v ovn gb rok erd e a e r n v e t me nt ad v or au d t or c t yg ove rnme nt
peronne chartabeorganzaton
AAERsunreatedtofrauduentfnanca statements 1
AAERs that do not specfy the year of the a eged fraud 1
AAERf rm f orwh c h d ata are n o t ava ab e n o t on C ompu t a t o r178
E x ec u Compn op roxy t a te men t are av a ab e m n gv arab e orf rau d
predate 1992when ExecuCompcoveragebegn
Sampeoff rm accuedoffraudbytheSEC50
Sampe offrm yearnotaccuedof fraud
AMatched ampeoffrm
F rm matc h edb ae d on t w odg t n du t ry c od e y e ar an d to t a a e t 100
BUnmatched ampe
Totafrm yearava abeonExecuCompthrough200117427
Le
F rmye ar of f rm ac cu e d of f raud 191
F rmye arw t h m n gre qu re d E xe cuC ompc omp e n at on or t o ck 685
h odn gv arab e
F rmye arw t h m n gre qu re dC ompu t at f n an c a t a te men t d ata 3518
Sampeoff rmyear notaccuedoffraudbytheSEC13033
We re qu re n onm n gop t on d at a t ob e n c u de dn t h e amp e Th e c a te g ory F rmye ar
w t h m n gre qu re dC ompu t at f n an c a t a te men t d ata n c u de f rmye ar n t h e f n an c a
ervce ndutryforwhchourmeaure ofexantefnancngcannotbeobtaned
Tab e 2p re e n t t h e n ame of e ac h of t he 50 amp e f rmac c u e d of f rau d
by t he S E C A t he t n d c at e t h e amp e c apt ure t h e w e pu b c ze d
a e g e d ac count n gf rau d of re c e nt y e ara w e a ome t hat w ere e
p u b c ze d
ntabe3 webreakdownthenumberoffraudandnonfraudfrm forthe
un mat ch ed amp e byn du t ryp ane A an dbyye arp ane B Tomake
p ane A of manag eab e ze w e b re ak ou t on y t ho e t w odg t SC c od e f or
w h c h w e hav e one ormore f rmac c u e d of f rau dM ot t w odg t S C c od e
havenofrm accuedoffraudbytheSECdurngthetme perod nth
tudyandweumptho etogether ntoan a other category
Th e f rt ob e rv at on on e c an mak e reg ardn gp ane A t h at t h e n c
denceoffrauddoe noteemto behghy concentratedna fewndutre
The50frm accuedoffraudare preadover21 dfferenttwodg tSC
code Thendutryw ththearget aboutenumberofa egedfraud
bu n e e rv c e S C 7 3 w h ch h a 1 0 f r m a c c u ed o f f ra ud B u n e e r
v c e f rm are ove rt w c e a k e y a t h e av e rag e f rmt ob e a cc u e d of f rau d
accountngfor8 52%ofthenonfraudfrm and20%ofthea egedfraud
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD121
TABLE2
L tofFrm AccuedofAccountngFraudbytheSEC
T me P erod of
NumberCompanyNameAegedFraud
1AdephaCommuncaton Corporaton19992001
2AdvancedTechnca Product nc19981999
3 An c om n c 19982000
4A re m of t n c 20002001
5Ah f ord comn c 20002001
6Atch onCat ngCorporaton19972000
7B au c h &L ombn c 19931994
8C rt c a P a th n c 20002001
9CyberguardCorporaton19971998
10Cy nkCorporaton1998
11D agn o t ek n c 19921993
12Dynegync 20012002
13EnronCorporaton19972001
14JoAn n S t ore n c 1992
15F neHot Corporaton19961997
16Gatewaync 2000
1 7 G u f o rd M n c 1 9 97 1 9 98
18H B O&C o19971999
19 HeathouthCorporaton19992002
2 0 G n c 1 99 5 1 99 7
21 n du n t ern at on a n c 1999
22 nternatonaThoroughbredBreeder1997
23K MartCorporaton2001
24SafetyKeenCorporaton19982000
25L e ga t o Sy t em n c 19992000
26Matera ScenceCorporaton19961998
27Max nternetCommuncaton nc2000
28Mcro Warehoue nc19941996
29Mcro trategy nc19982000
30Oak n du t re n c 19951996
31Phy canComputerNetworknc1996 1997
32P re me rL ae rSy t em n c 1998
33Qwet Communcaton nternatona nc20002001
34R teAd Corporaton19982000
35 S af TL ok n c 19971998
36S gnaTechnoogyCorporaton19961998
37 StructuraDynamc ReearchCorporaton19921994
38SunbeamCorporaton19971998
39S unr e M e d c an c 19941995
40Sw h e rn t e rnat ona n c 1996
41SymboTe c hn oog e n c 19982002
42Sy t e mSof tw are A oc n c 19941996
43 TexonCorporaton1999
44Thoma &BettCorporaton19981999
45Th or n du t re n c 19961998
46Tyconternatona LTD19972002
47WRGrac e &C o19921995
48WateManagementnc 19921997
49Wordcom nc19992002
50XeroxCorporaton19972000
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122MERC KSON MHANLON AND EL MAY D EW
TABLE3
SampeofF rm AccuedofAccountngFraudbytheSECandF rm NotAccuedUnmatchedSampe
byndutryandbyYear
P ane A B yn du t ry
12
NoA egatonA egedFraud
of F rau dF rm Frm
Twod gtPercentofPercentof
SCcode ndutryNameTotaTota
22TEXTLEMLLPRODUCTS1 03%200%
23APPAREL&OTHERFNSHEDPDS103% 200%
28CHEMCALS&ALLEDPRODS835% 600%
33PRMARYMETAL NDUSTRES3 00%200%
34FABRMETALEXMACH TRANSEQ173%600%
35NDL COMMLMACHYCOMPUTEREQ7 17%1200%
36ELECTROTHELECEQ EXCMP836%4 00%
7 TRANSPORTATONEQUPMENT294%2 00%
38MEASNSTR PHOTOGDSWATCHES483%6 00%
48COMMUNCATONS206% 600%
49ELECTRCGAS SANTARYSERV824%400%
50DURABLEGOODSWHOLESALE253%200%
51NONDURABLEGOODSWHOLESALE141%4 00%
53GENERALMERCHANDSESTORES155%200%
58EATNGANDDRNK NGPLACES202%200%
59M SCELLANEOUSRETAL1 89%1000%
67HOLDNGOTHER NVESTOFFCES041%200%
73BUSNESSSERVCES852%2000%
79AMUSEMENT&RECREATONSVCS0 84%200%
80HEALTHSERVCES1 90%200%
99NONCLASSFABLEESTABLSHMNT032%2 00%
OTHER NDUSTRES2987%0 00%
10000%10000%
P an e B B yy ear
NoA e g at on of F rau dF rmA e g ed F raudF rm
34
YearPercentofTotaPercentofTota
199274% 100%
199394% 20%
199497% 60%
199599% 40%
1996108% 120%
1997114% 200%
1998114% 180%
1999108% 120%
2000101%12 0%
200191% 40%
1000%1000%
Frm arecategorzeda thoeaccuedof accountngfraudandthoenotaccued ncoumn 1
wereportthefrm notaccuedoffraudby ndutrya apercentageofa frm notaccuedoffraud
ncoumn 2 wereportthepercentageofa frm accuedoffraudn theampe thataredrawn
f romt h e re p ec t v e n du t ryn c oumn 3 w e rep ort t h e f rmye ar n w h c h t he re n o ac cu a t on
of f rau d a ap e rce n tag e of a f rmye arn o t a c cu e d of f raudun matc h ed amp e n c oumn 4 w e
reportthepercentageofa frm accuedoffraudn theampe bytheyearn whchthea egedfraud
began
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD123
M c e an e ou re ta SC 59 a o ov e rre pre e n te dn t h e a e g ed
f rau d amp e f rm n t h n du t ry are ab ou t f v e t me more k e y
thantheaveragefrmtobeaccued offraudaccountngfor189%
ofthenonfraudampe and10%ofthefraudampe Otheroverrep
re e n te dn du t re n t h e f rau d amp e n c u de c ommun c at on SC
48an d f ab rca t edme ta SC 34 Ov era h owe v er t h e da t an t h
t ab e u gg e t t h at a c c ou n t ngf raud n o t o a t ed n an yp art c u ar
ndutry
e e x c u d ed b an k an d avn g an d o an f romour amp e b ec au e an m
portantcontrovar abetheproxyforthede reforexterna fnancng
a n o t ava ab e on C ompu t a t fort h e e f rm H owe v er t h re t rc t on
onyexcudedthreefrm uggetngthatun kethea egedaccountng
f rau d of t h e a t e 1980 e e E rc k on M ayh e w an dF e x 2000 t he
a egedfraud ofthe1990 andeary2000 donotappeartobeconcen
t ra te dn b an k an d avn g an d o an
PaneBof tabe3 preentthebreakdownofSECfrauda egatonby
yearwhereyearrepreentthefr tyearthea egedfraudtookpace not
t he y e arn w h c h t h e S EC mad e th e a e g a t on Th e a e g ed f raud b e gn
a e ary a 1992an d a a t e a2001Th e n umbe rof fraud b e gnn n gn a
gv e n y earrang e f roma ow of one n 1993t o ah gh of 10 n 1997Ov era
there nod cernabetrendovertmeandthea egedfraud arenotovery
cutered nanyg venyear
Foreachofthefraudfrm weco ectthemethodofearnng overtate
me nt a d o cumen t ed by t h e S EC w h e n t h eory t he S E C c ou d u e an
AAERforundertatngearnng a oftheAAERthatweob ervedwere
f orove rt a t ng e arn ng n un tab u ate d t a t t c w e f n d t hat 56% of
thefrm wereaccuedof overtatngtherrevenue SpecfcSECaccua
ton ncudereportng fa erevenue mproperyrecognzng revenue
channe tuffng prematureyrecognzng revenue nfatng revenue
recordng revenue from the sae pror to shpment and recognzng
revenueon nva dornonex tenta e The econdmo tcommonaccu
a t on c on t of v arou t yp e of c o t ore x p en e un d ert a t eme nt ap pyn g
to34%ofthefrm Exampeof uchexpene undertatementaccuaton
c ont an edn SEC AAER n c u de c rea t ed f c t t ou a e t ov ert a t n g
nventory mproperycapta zngexpene mpropercapta zatonof
m on of d o arof c omp an y e x pe n e an d n c udn gf ake t em n n
ventory Othermore pecfc ourceofovertatement ncudepurchae ac
countngormergerreatedaccountngentre eg cooke arreerve
bartertranacton eaeaccountngmanpuaton andovertatementof
nventory
Wea oexamnethe eveofmanagementaccued ntheAAER nunt
ab u ate d re u t w e f n d t hat t he h gh e t e v e of man age men t are mot
oftenaccuedof nvovementn theaccountngfraudn morethan50%of
the cases, the CEO or the CFO was accused of perpetrating the accounting
fraudthatedtotheAAER
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124MERC KSON MHANLON AND EL MAYD EW
4 Tet oftheReatonbetweenExecutveEquty ncentve and
AegedAccountngFraudandE tmate ofManagera Beneft
fromAccountng Fraud
41 MEASUREMENTOFEXECUTVEEQUTY NCENTVEVARABLES
nth ectonwe ntroducevarabe thatmeauretheexpectedbeneft
theexecutvecoudobtan fromartfca y nfatngthe tockprceofthe
f rmt h rou gh f raudu e nt a c t on F ort he f rm ac cu e d of f rau d a v arab e
aremeauredn theyearmmedateyprecedngthefr ta egedfraudyear
H owe v er f orome f rm t h e fraudy e ar t art e d p rort o 1992an d t h u
d ataon E x e cuC omp are n ot av a ab e f ort h e e f rmye ar n t h o e c a e
andwherethefraud tartednomorethantwoyear earer we ubttutethe
year1992fortheyearprortofraud nordertokeepthefrm nthe ampe
A equtyncentvevarabe areaggregatedovertheentremanagement
te am t e dn t h e p roxy t a t eme nt f ort he f c ay e arG e ne ray t h t h e f v e
mot h gh y c ompe n at ed e x ec u t ve Th e varab e are d ef n e d af o ow
SENSTVTY= thechangen vaueofthetopf vemanager
tockretr ctedtockand tockoptonportfo o
n re p on e t o a1% c h ang e n t h e t o ck p rc e
We d c u t h me au re f u rt h erb e ow
VESTEDSTOCK AND
OPTONSENSTV TY=thechangen vaueofthetopf vemanager
portfo oofexerc abe tockoptonandunre
t rc te d t o c k n re p on e t o a 1% c han ge n t h e
t oc k p rc e We d c u t h me au re f u rth e r
beow
WedefneSENSTV TYa theexpectedchangen thetopfveexecutve
f rmb ae d e q u t yw eat h f roma1% c h ang e n t o ck p rc e Th c han ge n
w e ath c on t of t h e umof t h e ch ang e n t h e v au e of t he e x ec u t ve e m
poy ee t o ck op t on p ort foo re t rc te d t o c k h odn g an d t o c k hodn g
Weaggregateacro thethreetoderve atota doar meaureofthe en
tvtyfor eachexecutveWeaggregateacro thefrm topfveexecutve
togetatota doar meaureforthetopmanagementteamofthef rmWe
a o e x amne t h e re a t on of t h e v e t ed p ort on of t h p ort f oo t ob e n g
accuedoffraudbecauethee hodng arethoethemanagercanm
medateybeneftfromandthumayprovde greater ncentve tocommt
fraud
Theexpectedweathchange fromtockandre trctedtockaree t
matedbymu tpy ngthemarketvaue ofthetockhod ng atyearend
theyearprortothea egedaccountngfraudfortheaegedfraudfrm
by 1% For stock options, we use the method of calculating their sensitiv-
t y t o t o c k p rc e ad e c rb e d byC ore an dGuay 2002 A t h ou gh de t a
u c h at h e n umbe rof op t on e x erc e p rc e an d t me t omatu rt y are
avaabe fromExecuComporthecurrentyearproxytatementforcurrent
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD125
yeargrant muchoftheedataareunavaab e nthecurrentyearproxy
tatementforpror grant Theoneyearapproxmatonmethoddecrbed
n C ore andGu ay 19992002re q u re n format on on yf romt h e mot
recentproxytatementtoe tmatetheen tvty oftheoptonportfooto
a c h ang e n t o ck p rc e Th e e n t v t y t o t o ck p rc e f ore ac h op t on h e d
etmateda
a o pt o nv a ue / a p r c e * p r c e * 0 0 1 = e d TN Z * p r ce * 0 0 1
where
d= natura ogarthmofexpecteddvdendye doverthe feofthe
opton
T=t me t omatu rt y of t he op t on n y e ar
N= cumuatvenormaprobab tyfunctonand
Z = n S / X + T r d + a 2 /2 / a T 1 /2 w h er e S t he p r c e of t he u n
de ryn g t o c k X t he e x erc e p rc e of t he op t on r t he n at ura
og art h mof t he r k f re e n t ere t ra t e an d a t he e x p ec t ed t o ck
re tu rn v o a t t y ov e rt he f e of t he op t on 7
42CONTROLVARABLES
We n c u d e av are ty of c ont rov arab e d e f ne d a f o ow
C EO=CHAR= n d c at o rv arab e t h at e t t o one f t he
h arman of th e B oard a o t h e C EO
NUMMTGS= thenumberofboardmeetng heddur
ngthef ca yearExecuCompvarabe
Nummtg
FNANC NG=an e x an t e meau re of af rm d e re
fore x te rna f n anc n g t an n d c a
t o rv arab e c od e d 1f t h e f rm v arab e
FREEC ASH e t han 0 5an d 0o t h er
w e FRE ECASHt d e f ne d a
Cahfromoperaton Computatdata#308
AverageCaptaExpendturet 3tot1 data#128
C u rren t A e t t _ d ata# 4
7We a o c on du c te d ou ranay u n g t he mx of c omp en at on a ra t o c ompu te d a t he
BackSchoe vaueofexecutvetockoptongrant andthevaueofre trctedtockgrant
d vd e dby t h e ex e cu t v e t o ta c omp e n at on e a aryb on u t he v au e of t o c k op t on
gran t an d th e v au e of re t rc te d t o c k gran t n t h e y earp rort of rau d a t h e me au re of
themanager equtycompenaton ncentve Thecoeffcentonth mxof compenaton
v arab e p o t v e an d gn f c ant n b o th amp e w h e n n oc on tro are n c u d edp v au e
of 0001n t h e matc h ed amp e an d 00001n t he un mat c he d amp e n t h e p re e n ce of
ou rc on t ro v arab e t h e co e ff c e n t on t he mxv arab e b e c ome e gn f c ant a t h ough
t g n f ca nt a t t he 0 1 0 e v e p v a u e o f 0 07 n b ot h a m p e W e ex c ud e th e m x o f
compenaton fromourmante t becaueth varabedoe notrepreentthetheoretcaex
antencentveof management Wethanktherefereeforpontngth outtou
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126MERC KSON MHANLON AND EL MAYD EW
LEVERAGE=totadebt Computatdata#34+ #9
ca e d by t o ta a e t d a ta# 6
MARKETVALUEOFEQUTY=themarketvaueofequtyofthef rm
Computatdata#199tme #25
ALTMANSZ SC ORE =p roxyf orr k of f n an c ad t re c a c u
a t ed b a e d on A t man 1968a u pdat ed
byB e g e yMn g an dWat t 19968
BOOKTOMARKET=thebookvaueof harehoder equty
Computatdata#216d vdedbythe
marketvaueofequty
EARNNGSTOPRCE= netncomeComputatdata#172per
haredvdedby endofyear tockprce
RETURNONASSETS=netncomeComputatdata#172 d
v d e d byy eare n d a e t d a ta# 6
SALESGROWTH=thepercentagechangen ae Compu
tatdata#12 fromtheproryeartothe
currentyearforthefraudfrm from
twoyear prorto thefraudtotheyear
prorto thefraud
AGEOFFRM=t h e e n g th of t me n y e ar t h e f rmh a
beenpubc ytradedfromtheCenter
forReearchn SecurtyPrce CRSP
M&ANY EAROFFRAU D =an n d c a to rv arab e e t e q u a t o on e
f t h e f rmh ad an acq u t on t h at
c on trb u t ed t o a e n t h e p rory eara c
q u t on n t h e f rt y e arof f rau d f or
f ra ud f r m V ar a b e e t eq ua t o o n e
f d a t a#249> 0 o t he rw e v arab e e t
equa tozero
TOTALAS SETS =t h e f rm t o ta a e t d a ta# 6 F orf rm
ac c u e d of f rau d t o ta a e t are me a
ureda oftheyearprecedngthea
egedfraud
STOCKVOLATLTY= thetandarddevatonreturnvoat ty
ofreturncacuatedover60month
F orf rmav a ab e on E x ec uCompw e
ue thevarabeBS_VOLATLTY Forthe
f rm n ot ava ab e on E x ec uCompw e
computethevarabeu ngtheCRSP
databae
CEOTENURE=thenumberofyeartheCEOha been
theCEOofthecompanyForf rm
avaabe onExecuCompwecompute
We a o e t mate t h e reg re on u n g t he p roxyf ord t re a d e ve op ed by Sh umw ay
2001 andournference areunchanged
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD127
thetenurea thenumberofyear be
tweenthevarabe BECAMECEOandthe
currentyearforfraudfrm thecur
rentyear theyearprortofraud
Forfrm notavaabe onExecuComp
wecomputethevarabe nthe ame
manneru ngdataobtanedfromproxy
tatement
M SSNGC EOTENURE =an n d c at o rv arab e e t e qu a t o on e f
t h e CEOTENU REv arab e m n g an d
zerootherw e
We n c u d e t wog ov ern an c e varab e Th e f rt C EO=C HARH e rma n
andWe bach2001 arguethatthegreatetfactoraffectngtheBoard
ofDrector effectvene t ndependencefromtheCEOMoreover
DechowS oanandSweeney1996 fndthathavnga Charmanwho
mu t an e ou y t h e C EO n c re a e t h e k e h ood of man pu at ng e arn ng
We a o n c u de t h e n umberof b o ardme et n g NU MMTGS a ap roxyf or
themontorngandeffortcontrbutedbyd rector Adam 2000 Vafea
1 9 99 9
WencudeF NANCNGtocontro fortheneedtoobtanexterna
fnancngA FREECASHbecomemorenegatvethefrm become co erto
e xhau t n g t n t ern af und an d t hu h a an n c en t v e t oman pu at e e arn
n g n an t c p a t on of ac ce n g t he c ap t amarke t B e cau e t h e re a t on
n o t k e y n e ar w e f oow D e ch ow S o an an d Sw ee n ey 1996 an d c re a te
an n d c at o rv arab e e t e qu a t o on e f t h e f rmw k e yw ant e x te rna
f n anc n gw t h n t h e n ex t t woy e ar e FREEC ASH e t h an ore q ua t o
05 an d zero o t he rw e Th c u tof f aume t h at f af rmre q u re e x t er
n a f n anc n gw t h n t h e n ex t t woy e ar t w t art t ak n g act on n ow tora e
thederedfund
WencudeLEVERAGEandALTMAN Z coretocontro forthepo b
t y t hat f n anc a y d t re e d f rm h ave g re at e rn c en t v e t o c ommt f rau d
t h an f rm t h at are n ot d t re e d A t man 1968 B e g ey Mn g an dWat t
1996 We a o n c u de e v erap e rf orman c e met rc n ord ert o c on tro
fortheeffectofpoorf nancaperformanceorweakenedfnanca tab ty
Pooryperformngfrm mayreortto accountngfraudnordertocoverup
therdefcentperformanceSpecfca y wenc udeEARNNGSTOPRCE
BOOKTOMARKETandRETURNONASSETSa meauredn theyear
prorto fraudtocontro forfnanca performance WencudeMARKET
9 n add t on t o t he g ov ern an c e v arab e t e d abov e w e a o n c u de t h e Gov e rn anc e n
d e xme t rc c omp e dbyGompe r h an dM et rc k 2003 w he re ava ab e f orou rmatc h ed
amp e f rm Th v arab e ame au re of h areh od errgh t b ae d on 24c orp ora t e g ov e r
n anc e p rov on c o e c te d by t he n v e t orRe p on b t yRe e arc h C en t erB e c au e w e o e 18
ob e rva t on f romou rfraud amp e w e d on o t ret an t h v arab e n ou rman an ay e Ou r
nferenceareunchangedn theub ampeforwhchwe canncudeth varabe andthe
Gove rnan ce n d ex v arab e n o t gn f c ant n t h e t e t
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128MERC KSON MHANLONAND E LMAY D EW
VALUEOFEQUTYtocontro for zeandSALESGROWTHtocontrofor
t h e po b t y t hat p ooryp e rformn g ow grow n gorh gh grow th f rm
may c ommt f rau dn ord e rt on c rea e o r u t an t h e r a e g row th 10We
a o n c u de AGEOFTHEFRM t oc on trof ort h e n c en t v e t o c ommt
f rau dp rovd e dby an n t a t o ck of fe rn g orbyh avn gn e w y u ed t o ck
F n ay w e n c u d e an n d c a to rv arab e M&AN Y EAROFFRAUD w h c h
tak e on av au e of on e f a p ort on of t h o e a e are f roman ac qu t on
Pror teratureprovdeevdencecon tentwthfrm managngearnng
p rort o an ac q u t on n orde rt ora e t h e rt o c k p rc e E rc k on andWan g
1 9 99 L ou 2 00 4
C omp e n at on t ruc t ure a c h o c e v arab e ou n g t a an e x p an a
t oryv arab e run t h e r k of e n dog en e t yp rob e m F ore xamp e n c a e
n w h c h mon torn g more d f f c u t f rm mayu e ah gh e re v e of n
c en t v e t o ck b ae d c omp e n at on D e me t zan dLe h n 1985Smt h an d
Watt 1992 GaverandGaver 1993andCore Hothauenand Larcker
1 99 9 t e xa ct y n t ho e c a e n w h ch m o n to r ng d f f cu t t ha t we
mgh t ao e x pe c t to e e ah gh e rk e h ood of f raudTh e p e c ay t rue
n t h e n t t u t on a e t t ng c on d e red n t h t u dy b e cau e ou re n t v t y
v arab e rep re e nt r k t h e e xe c ut v e b e ar n h c omp e n at on t ruc t ure
a t v are w t h t h e t o ck p rc e of t h e f rmf f rm provd e more n c en t v e
t h rou gh p ay r k w h en mon t orn g more d f f c u t an d f f rau d more
k e yw h en mon t orn g more d f f c u t t h en w e may e e t h e a o c a t on b e
tweenthe tructureofexecutvecompenatonandbengaccuedof fraud
mpyb e c au e mon torn g df f c u t n t he e f rm an dnot b e cau e t h e
tockbaedpayprovded ncentve formanager toengagenfraud
Wenc udeproxe forthedetermnantof equtyncentve a ndepen
dentvarabe nourregre onn anattempttocontrofortheendogenety
decrbedabove Wefo owthemodeofequty ncentve nCoreand
Guay1999 WencudeCEOTENUREandSTOCKRETURNVOLATLTY
10n add t on t on v e t g a t e w he t he rou ramp e of a e g ed f raud f rm h ad ow erg rowt h
durngthefraudperodwhch mayhaveedto therbengcaughtwe comparetheearnng
datatem#172 growthrate durngthefraudyearwth thoeofour matched ampeoff rm
Wefndthatthefraudfrm andnonfraudfrm ddnothave gnfcantyd fferentaverage
annuagrowthratedurngthefraudperod
11We re cogn ze t h at th e u e of an n t rume n ta v arab e V t w o t age e a t q u are ap p roa c h
thetandardtextbookfxforendogenety Howeverf ndngappropratentrument ex
t reme ydf f c u t an dw he n one u e n app rop ra t e n t rume nt t c an e a y b e t h e c a e t hat
t h e V e t mat e are more b a e d an dmore k e y t op rovd e t h e wrong t a t t c a n fe ren c e
than mpeOLSe tmate thatmakenocorrectonforendogenety LarckerandRutcu
2005 a o e e B oun dJaeg e ran dB ak e r1995 Th u w e d on ot mp e me n t a t wo t age
V e t mat on n ou rman t e t F u rt h er b e cau e t h e e nd oge n e ty n ou rt e t t h e corre a t ed
omttedvarabe typeofendogenetywecan ncudea etofdetermnant oftheendogenou
re gre orS ENSTV TY n ou rre gre on m t g at n g th e n c on t e nc y c au e d by th e c orre
a t ed omt t ed v arab e a umn gof c ou re w e t d on o t hav e a c o rre a t ed omt t ed v arab e
H owe v er w e n ot e t hat n t h e n t ere t of c omp et e ne w e e t mat e a t wo t age e a t q u are V
mode u n g t o c k p rc e a an n t rume nt f orS ENSTV TY n t h e t mat on t h e n f e re n ce
regardngthereatonbetweenfraudandequtyncentveare unchanged e no gnfcant
reaton
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD129
p rox e f ort he t w ov arab e n C ore andGu ay 1999 mode n o t n c u de d
n ou rmode f oro t h erre aon 2C EOTENU RE pred c t ed t ob e p o
t v e y re a t ed t o t h e e v e of e q u t yn c en t v e A d e c rb ed byC ore and
Gu ay 1999 ov ert me un ce rtan t y abou t aC EO ab t y re ov e dA r k
b orn e by t he C EOdue t oun ce rtan t y abou t h ab t y re du c ed t p o b e
t ompoe more n c e nt v e r k on h m c e te r p e rbu n add t on e q u t y
ncentve canbeued tomt gatehorzonprobem DechowandSoan
1991 oequty ncentve maybencreaeda retrementapproache
A d c u e d ab ov e D e me tzan dL e hn 1985 h ypo t he ze t hat f rm op
e rat n gn e p red c t ab e e n v ronme nt h ave h gh e rmon t orn g c o t an d
b e c au e of t h e e h gh e rmon t orn g c o t f rm n n o e re n v ron me n t w
h ave h gh e rman age raow n e rh pE x e cu t v e n f rm n w h c h mon t or
n g d f f cu t w k e y a o h a ve e a e r o pp or tu n t e t o c om m t f na nc a
accountngfraudThu wencudeSTOCKVOLATLTYa aproxyforth
uncertantyn ourregre on
43UNVARATETESTS
n t ab e 4 w e p re e nt d e c rp t v e t a t t c f ort he a e g ed f raud f rm
andbothampe ofnonfraudfrm matched ampeof100 nonfraud
frmsandtheunmatchedsampeof nonfraudfrms Foreachvarabewe
preentthemean tandarddevaton medanand owerandupperquar
t e V ar a b e t h at r ep re e nt d o a r a r e h o wn n m o n a n d a v ar a b e
arewnsorzedreset atthe1%and99% eves Forthef rmsaccusedof
f rau d a v arab e are me au red a of t he y e arp rorto t h e b egn n n gof t he
fraud
C omp arn g th e f rau d f rm w t h t he mat ch ed amp e of f rmre v e a e v
e ra gn f c ant d f f e re n ce n c on trov arab e b u t no t a t t c a y gn f c ant
dfferences ntheequ ty ncentvevarabesNotabed fferencesarethatthe
fraudfrmshaveah gherstockreturnvoat ty areon averageyounger
frm thathaveCEO wtha margnay hortertenurehavehgherSALES
GROWTHprortothefraudcommencngandhavemore nstancesofan
12 We include the BOOK TO MARKET ratio and MARKET VALUE OF EQUITYas described
above We contro for ndustry membersh p by matchng on ndustry n the matched sampe and
by including one-digit industry indicator variables in the unmatched sample Core and Guay
[1999] nc ude a varab e for free cash fow probems set equa to the rat o of operatng cash fow
ess dv dends to tota assets f the frm has ow growth opportunt es and zero otherwse The
varab e fo ows Jenson 1986 who argues that the combnaton of ow growth opportuntes
and hgh free cash fow creates agency probems that can be mt gated wth hgher eves of
equty ncentves Ths s the ony varab e n Core and Guays 1999 mode that s nsgnf cant
in their tests Because of its insignificance and because we already include a free cash flow
varab e fo owng Dechow, Soan, and Sweeney [1996] that serves as a proxy for the frms
externa f nancng needs and severa proxes for growth MARKET TO BOOK and SALES
GROWTH, we do not also include Core and Guays [1999] specific free cash flow variable
13We winsorize the matched sample variables over the distribution of the matched sample
plus alleged fraud firms 150 firms and w e winsorize the unmatched sample over the distri-
butonoftheunmatchedsampep usa egedfraudf rms13083f rms
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TABLE4
DecrptveStat tc onFnanca StatementVarabe andMarketba edMeaure forFrm AccuedofFraudbytheSECandfortheMatchedandUnmatchedSampe
StandardLowerUpper nMeann Medan
Variable Mean Deviation Quartile Median Quartile (p-value) (pvalue)
SENST VTY
Accuedoffraud19063640 01460419 1644
M atc he d amp e 1513730401090342108403460127
U nmatc h ed amp e 1019220401230326087800920080
VESTEDSTOCKANDOPTONSENSTV TY
Accuedoffraud15373239 00920 3011136
M atc h ed amp e 1238661500590276078203740187
U nmatc he d amp e 0810193800750220062701190087
CEO=CHAR
Ac cu e d of f raud 0760431 00100100
M at c he d amp e 0760 431001001000 7910792
U nmatc he d amp e 0710 450001001000 4150415
NUMMTGS
A c cu e d of f rau d 7203654006 00900
M at c he d amp e 6993 245006008000 7470449
U nmatc he d amp e 7072 795006009000 8060502
FNANCNG
Accuedoffraud01400351 00000000 0000
M atc h ed amp e 0020014100000000000002810202
U n mat ch e d amp e 0032017700000000000000350001
LEVERAGE
Accuedoffraud02060184 00370 1850325
M atc h ed amp e 0184016100130176031404910587
U n mat ch e d amp e 0229017600700223034903470269
MARKETVALUEOFEQUTY$ MLLONS
Accuedoffraud50129011 5638716820 41210425696
M atc h ed amp e 5759751783623212515036627499008680858
U nmatc h ed amp e 371895924722346668811127746004330141
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ALTMANSZSCORE
Accuedoffraud10711 12503890 8441422
M atc h ed amp e 1197140404510984167504140383
U nmatc he d amp e 1044105003670789135008610803
BOOKTO MARKET
Accuedoffraud00400 35301500 3250481
M atc he d amp e 0454034102520358055103800172
U nmatc h ed amp e 0487036402430409063300850018
EARNNGSTOPRCE
A c cu e d of f raud 00110107003000200050
M atc h ed amp e 0065058800150042006003800014
U nmatc he d amp e 0020012300180045006700690001
RETURNONASSETS
A c cu e d of f raud 00230178003500370087
M atc h ed amp e 0017033900210057008703040070
U nmatc h ed amp e 0042010200200051008900130022
SALESGROWTH
Accuedoffraud06501 38600640 2190607
M atc h ed amp e 0179034500270116025500220012
U nmatc h ed amp e 0188036900150102024900080001
AGEOFF RM
Ac cu e d of f raud 123913202507961851
M atc h ed amp e 18461988525963250100300043
U nmatc h ed amp e 206618995841442290100010001
M&ANYEAROF FRAUD
Ac cu e d of f raud 0300460 00000100
M at c he d amp e 0150 360000000000 0490031
U nmatc h ed amp e 015036000000 00000130001
TOTALASSETS$ MLLONS
Accuedoffraud390424 787000100 26281023 29446
M atc h ed amp e 414172972675136302784122360108851000
U nmatc h ed amp e 299432590917299397945825187504180008
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TABLE4 Contnued
Standard Lower Upper in Mean i n Median
Variable Mean Deviation Quartile Median Quartile (p-v alue) (p-value)
STOCKVOLATLTY
Accused of fraud 0534 0 264 0334 0 482 0669
Matched sample 0.400 0.172 0.267 0.363 0.513 0.002 0.004
Unmatched sample 0.376 0.205 0.243 0.348 0.485 0.000 0.000
CEOTENURE
Accused of fraud 4820 5927 0 000 2500 9000
Matched sample 6.540 5.589 2.000 5.500 10.000 0.084 0.014
Unmatched sample 6.037 7.072 1.000 4.000 9.000 0.154 0.142
MSSNG CEOTENURE
Accused of fraud 0140 0351 0 000 0000 0 000
Matched sample 0.060 0.238 0.000 0.000 0.000 0.151 0.103
Unmatched sample 0.100 0.300 0.000 0.000 0.000 0.423 0.346
All monetary amounts are in $ millions. Variables are as defined as follows: SENSITIVITY is a measure of how much the value of the top five executives portfolio of stoc k options,
restricted stock and stock changes in response to a one percent change in stock price. This variable is measured using the methodology described in Core and Guay [2002]. For the
firms accused of fraud this variable is measured in the year prior to the alleged fraud. VESTED STOCKAND OPTION SENSITIVITY is a measure of how much the value of the top five
executives portfolio of exercisable stock options and unrestricted stock changes in response to a one percent change in stock price. This variable is measured using the methodology
described in Core and Guay [2002]. For the firms accused of fraud this variable is measured in the year prior to the alleged fraud. CEO = CHAIR is an indicator variable taking
the value one if the CEO is also the Chairman of the Board, and zero otherwise. NUMMTGS is the number of times the firm s board meets, annually. FINANCING is an indicator
variable set equal to one when the firms free cash flow divided by lagged current assets is less than -0.5 and zero otherwise. LEVERAGE is measured as the firm s debt divided by
total assets. For firms accused of fraud, IEVERAGE is measured as prior to t he fraud. MARKET VALUE OFEQUITY is the market value of shareholders equity. For firms accused of
fraud, it is measured the year prior to the alleged fraud. ALTMANS Z SCORE is a proxy for risk of financial distress calculated based on Altman [1968] as updated by Begley et al.
[1996]. BOOK TO MARKET is the book value of shareholders equity divided by the market value of shareholders equity. For the firms accused of fraud, the ratio is measured as
of the year preceding the alleged fraud. EARNINGS TO PRICE is the earnings to price ratio. For firms accused of fraud, the ratio is measured as of the year preceding the alleged
fraud. RETURN ON ASSETS is net income divided by assets. For the firms accused of fraud, the ratio is measured as of the year prior to the alleged fraud. SALES GROWTH is the
percentage change in sales from the prior year to the current year (for the fraud firms from two years prior to the fraud to the year prior to the fraud). AGE OFFIRM is the length
of time in years the firm has been publicly traded (from CRSP). M&A IN YEAR OF FRAUD is an indicator variable set equal to one if the firm had an acquisition that contributed to
sales in the prior year (acquisition in the first year of fraud for fraud firms). (Variable is set equal to one if data item #249>0, otherwise variable is set equal to zero.) TOTAL ASSETS
are the firms total assets. For firms accused of fraud, total assets are measured as of the year preceding the alleged fraud. STOCK VOIATILITY is the standard deviation volatility of
returns calculated over 60 months. For firms in the Execucomp database this variable is the BSVolatility variable in Execucomp. We compute the variable in the same manner for
the hand-collected firms. (CO TENURE is the number of years that the CEO has been CEO of the firm. For the firms in the ExecuComp database, the variable is computed as the
number of years between the variable BE(CAMECEO and the current year. For fraud years it is measured as the year prior to fraud. For hand-collected firms, we compute the variable
in the same manner using dates obtained from the proxy statement. MISSING CEO 7TENNURE is an indicator variable set to one if the CEO TENURE variable is missing for the firm. All
v arab e are w n orze d a t t h e 1% and 99% e v e A pv au e are f romt wot a e d t e t
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD133
ac qu t on o c cu rrn gn t h e f rt y e arof f rau d n t e rm of me d an df fe r
e n c e t he re u t are mar w t h t h e ex c ep t on of t he f raud f rm h avng a
owerEARNNGSTOPRCE
Thereareanumberofdfferencebetweenthefraudfrm andtheun
matc h ed amp e of f rm Wt h re gard t o t he c ompe n at on v arab e t h e
d a t an t ab e 4 n d c at e t hat S ENSTV TY n ot t a t t c a y d f f e re n t be
tweenthefraudfrm andtheunmatched ampeu ngatwota edtet
p= 0092 TheVESTEDSTOCKANDOPTONSENSTV TYofthefraud
f rm a o n o t t a t t c a y d f f e re n t fromt hat of t he f rm n ot a cc u e d of
fraud In terms of control variables, the fraud firms are again, on average,
youngerfrm theyhavehgherSALESGROWTHprortothefraudcom
mencnghavegreaterSTOCKVOLATLTY andhavemorentance ofan
ac qu t on o c cu rrn gn t h e f rt y e arof f rau d n add t on t h e f rau d f rm
onaveragehavea owerRETURNONASSETSandhaveagreater kehood
ofneedngexternaf nancngMedandfferenceare m arbut ndcate
thatthefraudfrm havefewerTOTALASSETS haveowerEARNNGSTO
PRCE andhaveowerBOOKTOMARKETrato Theoweraccountng
return andgreaterneedforexternaf nancngfortheaegedfraudfrm
c on t e nt w t h t h e d e a t hat t h e e f rmare omew hat t rou b e dp o
byprovd ngat eata partofthemotvatonforthea egedaccountng
fraud
44 MULTVARATETESTS
n t h e c t on w e e x amn e w he t he re x ec u t ve c ompe n at on a o c a te d
wtha egedaccountngfraudaftercontro ngforcorporategovernance
f a ct o r t he d e re f ore xt e rn af n an c n gp e rforman ce me trc f rm ze
returnvoat tyandotherfactor Theconceptua modeforthe ogtana
y a fo ow
PrFraud= f equtyncentve governance performancemetrc
external financing, other controls). (1)
Webegnw ththeanay ofthe50fraudfrm comparedwththematched
ampeoff rm notaccuedofaccountngfraud
441 M atc h ed S amp e Re u t Tab e 5p re e nt t h e re u t u n g t he
matc he d amp e d e gn Th e d e pe nd e nt v arab e e q ua on e f t h e f rm
wa accuedofaccountngfraudbytheSECandzerootherwe Nether
S ENSTV TY n orV E STED STOC KAND OPTONSENSTV TY gn f
c ant y a o c a t edw t h ac c oun t ngf raud n an y of t he re g re on w h c h we
e t mat e b ot h w t h andw t h out c ont rov arab e C oumn A an dB pre e nt
t h e re u t f ort h e S ENSTV TY v arab e w t h out an dw t h c ont rov arab e
re p e ct v e yC oumn C an dD pre e nt t h e re u t f ort he v arab e V E STED
STOC KAND OPTONSENSTV TY n ord ert o t e t t h e a o c a t on w t h t he
e q u tyh odn g t h at t h e e xe c ut v e c an e mmed at e yAmong t h e c on
t rov arab e STOC KV OLATLTY gn f c ant w h e t h e o t he rc ont ro
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TABLE5
Reut ofaLogt Regre onComparng50Frm AccuedofFraudbytheSECwththeMatchedSampeofFrm
A B C D
PredctedCh SquareChSquareChSquareCh Square
VarabeS gnCoeffcentp-vaueCoeffcentp-vaueCoeffcent p-vaueCoeffcentp-vaue
NTERCEPT-07360000-20470107-07310 000-20400108
S ENSTV TY ? 0020032200010721
VESTEDSTOCKANDOPTONSENST VTY? 002103460 0080755
CEO=CHAR+ 01460 39101460 391
NUMMTGS -0033 0306 -0 033 0307
FNANCNG+ 047803760 4750377
LEVERAGE+2250 00842 2430084
MARKETVALUEOFEQUTY?0000 09420000 0961
ALTMANSZ+ 0310013003120129
BOOKTOMARKET?-03510 621-03550617
EARNNGS TO PRCE ? 2227 0443 2 220 0444
RETURNONASSETS?-01200 935-01120939
SALESGROWTH?08070 09608060096
AGEOFFRM--0013 0209-00130207
M&ANF RSTYEAROFFRAUD+0 474016904750 168
STOCK VOLATLTY + 2 729 0017 27291 0017
CEOTENURE? -00120770-001170769
MSSNG CEOTENURE? 139300571 39830056
Mode Lke hood Rato 1066 0302 34450 0005 0950 0330 34419 0005
N150150150150
Thstabe presentstheresutsof ogstcregressonswherethedependentvarabe san ndcatorvarabesetequa tooneforf rmsaccusedoff nanca accountngfraudand
z e ro o therws eOur s amp e ncud es 5 0 frms a c cused o ffna nc a a c co untng frms a nd 1 0 0 frms ma tched to the a eg ed fr a ud frms b a s ed o n nd us try 2 d g tS Cco d e y e ar a nd
frm sze tota assets n the year pror to the aeged fraud A varabes are defned n tabe 4 A p-vaues are two ta ed except where a sgn s predcted
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD135
v arab e are n gn f c ant Th e e re u t u gge t t h at onc e n du t ry and ze
havebeencontroedforv amatchnguncertantyntheoperatngenv
ronmenta proxedbySTOCKVOLATLTY theony gnfcantpredctor
offraud
442 U n mat ch e d S amp e Re u t n t h e c t on w e p re e n t t he re u t of
t h e ame t e t d e c rb e dn t h e pror e c t on bu t we n ow c omp are t h e 50
fraudfrm wththebroadunmatched ampe 13000+frm yearober
vaton ofnonfraudfrm wthdataonExecuCompTabe 6preent the
b a c r e g re o n re u t T he r e u t n t ab e 6 c o u mn A a nd C r e ve a a g
n f c an t yp o t v e a o c a t on b et w ee n f rau d an d SENSTV TY p =0007
andVESTEDSTOCKANDOPTONSENST VTY p= 0012 whennocon
t rov arab e are n c u de dn t h e re g re on Th u n a arge amp e w t h n o
ad d t ona c ont ro t h ere a t a t t c ay p o t v e a o c a t on b et w ee n e xe c
u t v e e q u typ ortf oo n c en t v e an d t h e k e h ood of c ommtt n gf rau d
We t he n ad d t he c ont rov arab e t o t h e re gre on B e c au e t h e amp e
un mat ch e dw e a o n c u de n du t ry f x e d e ff e ct a t t h e on e dg t S C e v e
coeffcent arenottabuatednthe nteret ofbrevty Afteraddngthee
c ont ro w e f n d t hat c on t en t w t h t ab e 5S ENSTV TY an dV ESTED
STOC KAND OPTONSENSTV TY are no t gn f c ant y a o c a t edw t h ac
c oun t n gf rau dp =0 266andp = 0242re p e c t v e yTh e c o ef f c e nt on
e v era c on trov arab e are gn f c ant F ore x amp e t he f raud f rm ge ne r
ay h ave h gh e rSTOC KVOLATLTY p=0005 on e t a e d an d are more
k e y t oh ave a e a t trb u t ab e t o an ac q u t on n t h e f r t y e arof f raudp =
0024on e t a e d
45 MANAGERALBENEFTSDERVEDFROMTHEACCOUNTNGFRAUD
We ao e x amn e e x p o t t o ck op t on e xe rc e an d t o c k ae t od et e r
mnewhetherthere evdencethatexecutve atfraudfrm od more
equtythanexecutveat nonfraudfrm Therearereaon tobe evethat
e v en f e q u tyn c e n t ve are a o c a te dw t h f rau d e x p o t t o ck ae an d
op t on e x erc e w ou dn ot b e a o c a t edw t h f raudF ore x amp e e x ec u
tve maynotwanttodrawattentontothefraudbyengagngn unuua
e v e of e n g n add t on f t h e f rau d p e rp e tra te dn ord e rt ob uy ome
tmetobecomeproftabeor ncreaenonfrauduentperformanceand
theexecutvedoe th wththebe efthattheyw notbecaught thenthe
e x ec u t ve w w ant t od e ay a e u n t t h e f rm prc e e v en h gh e rt han
w h at t d u rng t h e f rau dp erod F n ay e x ec u t ve c an u e t h e h are
a c o a t e ra f oro an t hu e x tra ct n gw e ath w t h out t h e a ct u a a e of t h e
t o ck F ort h e e re aon w e b e e v e t he e x an te me au re of n c e n t ve w e
u e n ou rman an ay p rovd e ab e t te rt e t of ou rre e arc h q ue t on H ow
e v e rw e p e rformt he t e t on a e of h are an d e x erc e of t o c k opt on
forcompetene
Toprovdeempr caev denceonthee queton wecompareopton
e x erc e t o ck ae an d cah c omp en at on ov ert h e f rau dp erod f ort he
f rau d f rm re at v e t o th e n on f rau d f rm We re port t he e re u t n t ab e 7
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TABLE6
Reut ofaLogt Regre onComparng50Frm AccuedofFraudbytheSECwththeUnmatchedSampe
A B C D
PredctedChSquareCh SquareCh SquareCh Square
VarabeS gnCoeffcentp-vaueCoeffcent p-vaue Coeffc entp-vaueCoeffcentp-vaue
NTERC EPT5 703000070840000 5684000070950000
S ENSTV TY ? 0 101000700600266
VESTEDSTOCKANDOPTONSENSTVTY ?0109 00120067 0242
CEO=CHAR+ 059600410 6000040
NUMMTGS -0027 0299 -0 026 0306
FNANCNG+ 084800520 8480052
LEVERAGE+-0760 0199-07550200
MARKETVALUEOFEQUTY ?00000 29900000228
ALTMANSZ +-02570 062-02560062
B OOKTOMARKET? 045203390 4550337
EARNNGSTOPRCE?2 2 2 2 0 1 7 4 2 2 3 2 0 1 71
RETURNONASSETS?-29190 052-29160052
SALESGROWTH?03710 17203720171
AGEOFF RM-00180068-00180 067
M&ANF RSTYEAROFFRAUD+ 0 6 6 8 0 0 24 0 6 6 6 0 0 2 4
STOCKVOLATLTY +1849 00051 8610005
CEOTENURE?-00220 407-00220401
MSSNG CEOTENURE?02860 52502770540
Mode Lk e h oodRat o5246002267824000046090032679340000
N13083130831308313083
h t ab e p re e n t t h e re u t of og t c re g re on w h e re t h e d ep e nd e nt v arab e an n d c a t orv arab e e t e qu a t o on e f orf rmye ar w h ere t he f rm ac cu e d of f n an c a
a c cou nt n gf rau d an d zero o t he rw e Ou ramp e n c u de 50f rm ac cu e d of f n an c a a c c ou n t ngf raud an d 13033f rmyear a o t he rf rmye ar on E xe c uC ompf orw h c h n o
accusatonoffraud smade A varabesaredefned ntabe 4 Onedg t ndustrynd catorvarabesarenc udedn theregressonestmatonbutcoeffc entsaresuppressedabove
f or mpc t y A pv au e are t wot a e d e x c ep t w he re a gn p red c t ed
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TABLE7
StockOptonExerc e StockSae andCahCompenatondurngFraudPerod
A egedFraudFrm veru MatchedSampeA egedFraudFrm veru UnmatchedSampe
A egedFraudMatchedA egedFraudUnmatched
Frm Sampe Sampe Dfference p-vaue F rm Sampe Sampe Dfference p-vaue
StockOptonExerc e
#opton exercedt/#exerc abeopton t
Mean 244% 273% -29% 0645 244% 229% 15% 0774
Median 07% 94% -87% 0009 07% 52% -4 5% 0085
# op t on e x e rc e d t/ # t o ta op t on h e d t 1+# op t on grant t
Mean 74% 83% -09% 0640 74% 88% -14% 0411
Medan 08% 40% -32% 0009 08% 22% -14% 0049
# op t on e x e rc e d t/# op t on e x erc e d t +# e n dn g e x erc ab e op t on t
Mean 123% 143% -20% 0396 123% 132% -09% 0643
Median 17% 68% -51% 0017 17% 41% -24% 0 079
$ re a z e d f rome x erc e t / $ re a z e d f rome x erc e t + n trn c v au e of e x erc ab e op t on t
Mean 225% 219% 06% 0 873 225% 200% 25% 0414
Median 30% 102% -72% 0115 30% 75% -45% 0369
StockSae
# n e t h are od t /# h are h e d t 1
Mean 03% 29% -26% 0258 03% -06% 0 9% 0664
Medan 00% 00% 00% 0363 00% 00% 00% 0783
$ v au e of n e t h are od t / $vau e of h are h e d t 1
Mean 12% 29% -17% 0389 12% -05% 1 7% 0365
Median 00% 00% 0% 0816 00% 00% 00% 0538
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TAB LE 7 C ont n u ed
Alleged Fraud Firms versus Matched Sample Alleged Fraud Firms versus Unmatched Sample
Alleged Fraud Matched Alleged Fraud Unmatched
Firm Sample Sample Difference p-value Firm Sample Sample Difference p-value
C ah C ompe n at on durn gF raudP e rod n $m on
Saary+ bonuoverfraudperod
Mean $4.478 $3.742 $0.736 0.104 $4.478 $3.142 $1.336 0.001
Median $2.434 $2.804 -$0.370 0.716 $2.434 $2.506 -$0.072 0.331
S a ary +b onu c a e d by ave rag e t ot a a e t ov e rt he f raudp e rod
Mean 0.7% 0.7% 0.0% 0.957 0.7% 0.5% 0.2% 0.113
Median 0.4% 0.4% 0.0% 0.377 0.4% 0.3% 0.1% 0.425
Saary+ bonu+ otherca hcompenatonoverfraudperod
Mean $5.217 $3.960 $1.257 0.022 $5.217 $3.295 $1.922 0.001
Median $2.854 $2.917 -$0.063 0.489 $2.854 $2.562 $0.292 0.108
S a ary +b onu +o t he rc ah c ompe n at on c a e d by av erage t o t a a e t
Mean 0.7% 0.7% 0.0% 0.834 0.7% 0.5% 0.2% 0.046
Median 0.4% 0.4% 0.0% 0.534 0.4% 0.3% 0.1% 0.692
Difference in means p-values is based upon a t-test, while difference in medians is based upon Wilcoxon signed rank test. Variables are defined as follows: #
options exercisedt is the variable SOPTEXSH from ExecuComp; exercisable optionst_- is the variable UEXNUMEX from ExecuComp; total options heldtl
is the sum of the variables UEXNUMEX and UEXNUMUN and current grants is the variable SOPTGRNT from ExecuComp; $ realized from exercise is the
variable SOPTEXER from ExecuComp and the intrinsic value of exercisable optionstl is the variable INMONEX from ExecuComp. Salary and Bonus are
both from ExecuComp variables of the same name. Assets are taken from Compustat (data item #6). For stock sales we gathered the data from Thompson
Financial Insider Filing Data Feed. The number of shares sold is the net of acquisitions (negative values) and sales, excluding sales of shares just gained from
option exercise (positive values) (variable NSHR). The shares held are as of the beginning of the year (SHRHELD). The value of the transactions is computed
as the stock price at the time of the sale or purchase (TPRICE) multiplied by t he number of shares in the transaction. All variables are summed over the top 5
executives for ExecuComp variables and over all officers for Thompson variables. All variables are winsorized (reset) at 99% and 1%.
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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD139
Wefndno evdencethatfraudfrmexecutveexerc e tockopton mea
ured nnumberofopton andvaue toagreaterdegreethanexecutve
atthenonfraudfrm netherthematched ampeor theunmatched am
pe Forexampefraudfrm executve exerceapproxmatey24%ofther
begnnngoftheyearexercab eopton whe thematchedunmatched
ampeexecutveexerc e27% 23% Themedannonfraudfrmexecu
tveactuay exerc edmoreopton thanthemedanfraudfrm executve
d u rn g th e f rau dp erodh ow e ve rt h e e re u t are on ymargn ay gn f
cantfortheunmatched ampe Tabe7 a o ndcatethatfraudfrmexec
u t v e d on o t e gn f c ant ymore me au red a t t h e mean an dmed an of
ther tockhodng thandomanager atnonfraudfrm
nterm ofcah compenaton wefndthatfraudfrmexecutve earned
on av erage $ 448m on p ery e arove rt he f raudp e rodn t e rmof a ary
an db on u an d $ 522m on p ery e arove rt he f raudp e rodn t e rmof
totaca hcompenaton14Wth theaveragenumberofyear offraudfor
ou ramp e b e n g 23 y e ar t h t ran at e n t o t h e t op f v e e x e cu t v e n ou r
av erage f rme arn n g abou t $ 12m on d o ar n t o ta c ah c ompe n at on
wheperpetratngthefraud ncontrat theexecutve atthematched
amp e of f rme arn ed on y $ 396m on p e ry earon av erage n t o ta c ah
c omp e n at on du rn g t h ame p erodTh df f ere nc e gn f c ant a t t h e
002e v e b u t t he me d an are n o t gn f c ant ydf f e re n t p =0 49 n
ordertocontro for zedfference we caethecompenatonmeaure
by t h e t ot a a e t of t h e f rmAf t erd on g t h w e f n dn o e vd en c e of a
tatt ca dfferencen theannua cahcompenatonof thefraudfrm
comparedwththematchedampeof nonfraudfrm durngthefraud
perodanda0 2%dfferenceon average nthe caedmeaurere atveto
theunmatched ampe p= 0046
We n t e rp ret t h e d at an t ab e 7 a f a n g t ou pp ort t h e c on c u on t h at
fraudfrmmanager exerc edmore tockoptondurng thefraudperod
t h an ddman age ra t n on fraud f rm Sm ary c on t e nt w t h t h e f n dn g
ofDechow Soan andSweeney1996 wenterpretthedata ntabe7 a
f a n g t ou pp ort t h e con c u on t h at fraud f rmman age r odmore of
ther tockhodng thanddmanagerat nonfraudfrm
5C on c u on
Weexamnewhetherthencdenceofa egedaccountngfraud a oc
atedwthexecutveequtyncentve Someofthearget accountngfraud
n h t ory o c cu rre dn t h e a t e v eray e ar e adng t o t h e w e k now n up
heava ntheaccountng ndutryand weepng eg atveandreguatory
c h ang e Th e e e ve n t h ave e ft e g a t or re gu at or p rac t t on er an d
academc earchngforcaue oftheefraud Undertandngtheundery
n gf orc e t h at g av e r e t o t h e e f rau d an e ce aryp re cu rort o e f fe c t ve y
14 Total cash compensation is computed as the sum of the variables salary + bonus + all other
payfromExecuComp
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140MERC KSON MHANLONAND E LMAY D EW
preventngfutureoccurrence Manyhave uggetedthattheexpanaton
e nthencentve andopportunte forperona ganfacedbyexecutve
Ou ramp e c on t of f rm e xp c t y ac c u e d of a cc oun t n gf rau dby t he
SECdurngtheperodJanuary1996toNovember2003Afterrequrngthe
av a ab t y of c ert an f n anc a d a ta w e h ave af n a amp e of 50f rmt h at
wereaccuedof fraudbytheSECwhchweca thefraudfrm Wecompare
t he f raud f rm w t h t w oamp e of f rm t h at w e re n o t a cc u e d of f rau d
F rt w e c omp are t he f raud f rm w t h amat ch e d amp e of f rm n w h c h
t h e mat ch e are b a e d on ze y e aran dn du t ry S e c on dw e c ompare t he
f rau d f rm w t h an un mat ch ed amp e of f rmc on t n g of a re man n g
frm yearon ExecuComp
Weet mateavaretyofequty ncentvemeaure forthetopfveexecu
t v e a t e a c h f rmf oc un g p e c f ca y on t h e e xp e ct e d ch ang e n v au e of
theexecutve tockandoptonbaedportfoo toa1% tockprcechange
whchwedenote en tvty naddt onaanay e weexamnewhether
t h ere e v d en c e th at ex e cu t v e a t f rm ac cu e d of f raud y t e mat c ay
e t o ck an d e xe rc e op t on du rn g t h e pe rod of t he a e g ed f raud t o a
greaterextentthanexecutve nthematchedandunmatched ampe of
contro frm
Th e e mprc a an ay re ve a n o c on t e nt e v d e nc e t ou pp ort t h e con
c u on t hat t he p robab t y of ac count n gf rau d n c re an g n t h e e n t v t y
ofexecutve totaequtyor veted tockandtockoptonba edweathto
c han ge n t o ck p rc e We a of n d t h at man age ra e x e rc e of t o c k op
t on an dman ag e ra t o ck ae are n ot gn f c ant yh gh e rf orf raud f rm
t h an f orn on f rau d f rm Th u t h e e re u t t and n c ont ra t t o a e rt on
bypo cymaker thatncentvefrom tockbaedcompenatonandthere
u t n g e q u t yh odn g n cre a e t h e k e h ood of ac count n gf rau d
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