The Advisors' Blog

This recent study from B-school professors at UT Dallas, Berkeley, UNC and China Europe International Business School examines whether CEO equity pay motivates fraud. In short, there’s a strong correlation with earnings management within the confines of GAAP, but fraud only tends to arise when company performance is looking desperate. Here’s the abstract:

Although CEO equity incentives are commonly believed to be positively associated with accounting manipulation, the empirical evidence is mixed (Armstrong, Jagolinzer, and Larcker 2010; Edmans, Gabaix, and Jenter 2017). We revisit this relation by first recognizing that accounting manipulation ranges from permissible interpretation of GAAP to outright fraud.

While equity incentives motivate CEOs to present more favorable performance through accrual earnings management, they do not inherently lead to fraud, largely because of the substantially higher costs of fraudulent behavior. Instead, fraud arises when CEOs face heightened pressure, such as prolonged poor performance. The positive relation between equity incentives and fraud emerges only under these conditions and is concentrated when equity incentives are excessive.

We thus reestablish the positive relation between equity incentives and accounting manipulation, but with a distinction prior work has overlooked. The relation is unconditional for within-GAAP earnings management and conditional on heightened pressure for accounting fraud.

– Liz Dunshee