two essays in corporate finance

TWO ESSAYS IN CORPORATE FINANCE



DISSERTATION

Presented in Partial Fulfillment of the Requirements for
the Degree Doctor of Philosophy in the Graduate School of
The Ohio State University

By
Natasha A. Burns, M.B.A.


The Ohio State University
2003




Dissertation Committee: Approved by
Professor René M. Stulz, Advisor _________________
Professor Jean Helwege Advisor
Professor G. Andrew Karolyi Graduate Program in
Business Administration

Copyright by
Natasha A. Burns
2003
ii

ABSTRACT



This dissertation analyzes restatements of financial statements and the use of cross-
listed stock by foreign firms in acquisitions of U.S. firms. The first essay, presented in
Chapter 2, examines the Chief Executive Officer’s (CEO’s) incentives for using aggressive
accounting that might result in a restatement. Specifically, it examines how the composition
of the CEO’s compensation affects these incentives. Using a logistic regression to explain
misreporting in a given firm-year, this essay shows that CEO’s whose compensation depends

more on options are more likely to use aggressive accounting that results in a restatement.
Further, when the CEO’s option compensation deviates from its optimal level, misreporting is
more likely. An increase in the equity and restricted stock component of compensation has no
impact on incentives to engage in such risky accounting. The use of long-term incentive plans
and restricted stock do not extend a manager’s horizon relative to the short-term focus
induced by options. Finally, we examine the market reaction to the announcement of a
restatement. It is more negative for those restating firms in which the exercise of options was
greater during the misreported period, providing support for the idea that options provide a
‘camouflage’ for insider trading.
The second essay, presented in Chapter 3, examines the role of cross-listed stock in
foreign acquisitions of U.S. firms. Recent research states that there are important disclosure
and legal implications for foreign firms that cross-list on a U.S. exchange. By cross-listing, a
foreign firm reduces its cost of an acquisition made with equity by enhancing the rights of its
minority investors and by decreasing barriers to ownership of its shares by U.S. investors.
iii

Cross-listed firms using equity to finance an acquisition pay, on average, 10% less than non-
cross-listed firms paying with cash, as measured by the target’s premium around the
announcement of the acquisition. Despite this benefit, cross-listed firms use equity less often
than U.S. firms because of factors affecting foreign firms but not U.S. firms, e.g., home bias
and investor protection. Using a sample of forty-four cross-listed bidders acquiring U.S.
targets with equity, the essay shows that cross-listed firms from countries with poorer
investor protection use equity less often than those from countries with greater investor
protection. Moreover, they pay a higher premium when using equity. Thus, even after
bonding to the U.S. legal regimes via its cross-listing, investors are still wary of the firm’s
home country legal protections. We test Hansen’s (1987) hypothesis that equity financed
acquisitions enable the bidder to share the risk with the target that the bidder overpaid. We
find that acquirers are more likely to use equity in acquisitions involving targets with greater
growth opportunities that are more difficult to value, supporting Hansen’s hypothesis.
Finally, we find that while non-cross-listed firms use favorable exchange rate movements to

bid more aggressively, cross-listed firms do not.

iv

ACKNOWLEDGMENTS



I would like to thank my advisor René Stulz and my committee members Jean Helwege
and Andrew Karolyi for their guidance and insightful feedback that helped make this dissertation
possible.
I also thank Craig Doidge, Jim Hsieh, Jan Jindra, Anil Makhija, Christof Stahel, Siew
Hong Teoh, Karen Wruck and seminar participants at Auburn University, The Ohio State
University and The University of Georgia for helpful comments and suggestions.
Finally, I am grateful to W.C. Benton, Steve Buser and Jean Helwege for their words of
encouragement and advice; Melanie Roy for help with data; to my family for their support; and to
my precious daughter, Shefali, for keeping the joy in my life during this time.


v

VITA



August 24, 1971 … Born – Columbus, Ohio

1993 Bachelor of Science in Computer Information Science,
Ohio State University, United States.

1996 Master of Business Administration, Michigan State University,
United States.




FIELDS OF STUDY

Major Field: Business Administration

Concentration: Finance
vi






TABLE OF CONTENTS



ABSTRACT ii
ACKNOWLEDGMENTS iv
VITA v
LIST OF TABLES ix
LIST OF FIGURES xi
CHAPTER 1 1
CHAPTER 2 3
2.1. Introduction. 3

2.2. A primer on restatements 6
2.3 Literature review and development of hypotheses 8
2.3.1 The effect of option compensation. 8
2.3.2. Convexity. 12
2.4. Data and Methodology 15
2.4.1. Introduction of sample 15
2.4.2. Summary Statistics 16
2.4.3. Characteristics of restating firms 17
2.4.4. Discretionary accruals 19
2.5. Measures of CEO compensation 21
2.5.1. Option sensitivity. 21
2.5.2. Sensitivity of restricted stock and equity holdings 24
vii

2.5.3. Long term incentive plans 24
2.6. The effect of compensation. 24
2.6.1. Convexity. 30
2.6.2. Abnormal compensation. 31
2.7. Announcement reaction. 32
2.8. Conclusion 34
CHAPTER 3 37
3.1. Introduction. 37
3.2. The Determinants of financing. 40
3.2.1. Growth opportunities and the limit of debt financing 40
3.2.2. Risk sharing and signaling 41
3.2.3. Benefits of cross-listing. 41
3.2.4. The role of exchange rates 45
3.3. Data and Results. 46
3.3.1. Variables. 49
3.3.2. U.S. vs. cross-listed acquirers 52

3.3.3. Cross-listed acquirers 53
3.3.4. Premiums 56
3.4. Conclusion 61
CHAPTER 4 63
LIST OF REFERENCES 65
APPENDIX A: Tables 71
APPENDIX B: Figures 101
APPENDIX C: Estimation of discretionary accruals 104

viii


APPENDIX D: Estimation of equity incentive deviation from optimal equity incentives 105
APPENDIX E: Probit used in Heckman estimation 108
ix






LIST OF TABLES



Table 1: Restatements for the period 1995 - 2002 71
Table 2: Measurement of variables 74
Table 3: Characteristics of restating firms 75
Table 4: Time series of discretionary accruals around the first year of alleged manipulation. 76
Table 5: Firm-year characteristics 77

Table 6: Logit regressions of determinants of restated year 78
Table 7: The effect of Gamma 82
Table 8: Deviations from optimal compensation 84
Table 9: Announcement reactions 85
Table 10: Distribution of sample by year and country 87
Table 11. Description of financing. 90
Table 12: Probit regressions of factors affecting method of payment for cross-listed and U.S.
bidders of U.S. firms 91
Table 13: Probit regressions on the use of equity in acquisitions by cross-listed firms 92
Table 14: Cumulative abnormal returns 95
Table 15: Cross-sectional weighted least-square regression results of premiums to shareholders of
US targets of cross-listed and non-cross listed foreign acquirers 96
Table 16: Cross-sectional weighted least-square regression of premiums to target shareholders of
U.S. and cross-listed acquirers 97
Table 17: U.S. Target Premiums of cross-listed acquirers 98
x

Table 18. Determinants of equity incentives. 107
Table 19: Probit regression used in Heckman estimation 108
xi

LIST OF FIGURES



Figure 1. Timeline for a restating firm that announced in January 2000 that it is restating
financial statements for fiscal years 1998 and 1999. 101
Figure 2. Median Discretionary Accruals (DCA) of restating and non-restating firms in the three
years around the initial year of GAAP violation. 102
Figure 3. Cummulative Abnormal Returns in the 120 days around the announcement of the

restatement 103


1

CHAPTER 1


INTRODUCTION



Recently, there has been an increase in the number of restatements issued by larger firms.
Previous literature has focused on market-based incentives affecting a manager’s choice to use
aggressive accounting practices that might result in restatements. However, it does not seem
likely that a manager would make such a choice absent personal incentives because managers
face personal risks for making these choices. In the first essay, presented in Chapter 2, we
examine the CEO’s personal incentives to make such choices.
We examine the role played by the different components of the CEO’s compensation
package, with a focus on options. We focus on options because the increase in restatements has
coincided with the increase in the use of options as a tool to align the interest of managers with
shareholders. More importantly, options have an asymmetric payoff with respect to stock price
that mitigates the downside risk of a stock price movement. This is in contrast to other
performance-based compensation, e.g., restricted stock, long-term incentive plans (LTIP) and
equity holdings that have a symmetric payoff with respect to the stock price.
The results show that the CEO’s incentives from options are positively associated with
the likelihood of misreporting. Despite the fact that equity, restricted stock and long-term
incentive plans expose managers to the downside risk of a stock price movement, these
components of the CEO’s compensation package are not significantly associated with
2

misreporting. Results are also consistent with the notion that options provide ‘camouflage’ in
that the market reaction to the announcement of the restatements is significantly and negatively
associated with the exercise activity of the CEO in the misreported period.
Chapter 3 presents an essay on the factors affecting the method of payment in a foreign
acquisition. In addition to the factors that U.S. acquirers must take into account in an acquisition
of a U.S. target, foreign firms must also take into account their home-country legal environment,
disclosure standards and the home bias effect. When a firm cross-lists, it effectively “bonds”
itself to the U.S. legal regime and disclosure standards. Because U.S. investors are accustomed to
greater legal and disclosure standards than offered by most countries, a U.S. investor may not
want to accept the shares of a cross-listed firm if cross-listing does not fully “bond” the firm to
U.S. legal standards.
Results indicated that after cross-listing, home country legal standards, but not disclosure
standards, still affect the likelihood of the foreign firm using equity. Foreign firms from countries
with poorer legal standards use equity less often. They are also charged a higher premium by U.S.
target shareholders for their shares. We examine other factors that determine the use of equity and
affect the premiums in foreign acquisitions U.S. firms. We find that non-cross-listed foreign firms
bid more aggressively when the dollar has depreciated relative to the home country currency, in
contrast to cross-listed firms that do not. Another important finding is that the growth
opportunities of the target affects the choice of equity for cross-listed firms, in that they are more
likely to use equity when the target has greater growth opportunities. This supports Hansen’s
(1987) risk-sharing hypothesis that equity may be used in an acquisition to cause target
shareholders to share in any post-acquisition revaluation effects.
3




CHAPTER 2

DOES PERFORMANCE-BASED COMPENSATION EXPLAIN RESTATEMENTS?



2.1. Introduction.

In his September 1998 remarks, Arthur Levitt, the then chairman of the SEC, suggested
that the desire of executives to increase the value of their options gave them incentive to
manipulate their accounting numbers.
1
Back in 1997, when large option grants were beginning
to become more prevalent, L. Dennis Kozlowski, former CEO of Tyco (currently under
investigation for defrauding shareholders), characterized options as a “free ride… a way to earn
megabucks in a bull market with a hot company.”
2
Is the earnings management to which Levitt is
speaking motivated by firms trying to look like a “hot company” in order to earn those
“megabucks” while in a bull market? Is the recent increase in the number of restatements
coinciding with the increased use of large option grants evidence of what these men said? In this
paper, we examine restatements that are due to ‘purposeful’ accounting choices in order to
understand whether and how management’s incentives, through their compensation contracts,
affects the likelihood of engaging in unusual accounting practices that result in restatement.

1
Levitt (1998).
2
Lublin, J., Executive Pay (A Special Report)- View From the Top: A CEO discusses his unusual pay package
with a shareholder activist. The Wall Street Journal, April 10, 1997.
4

If aggressive accounting affects stock prices, then executives, whose wealth is tied to equity
valuation, will be motivated to maximize their wealth through aggressive accounting.
3

Bebchuk, Fried and Walker (2002) argue that options enable managers to extract rents,
encouraging focus on short-term price at the expense of long-term fundamental value by allowing
easy exit strategies. Holding option compensation causes executive wealth to be a convex
function of the stock price. Because of this convexity, executive’s exposure to the stock price
from options changes with firm value. Thus, increasing the stock price benefits management
through their option holdings, but the magnitude of their loss is limited in the event of a decline in
the stock price. Management is rewarded in the good times, but not hurt as much in the bad times.
This asymmetric feature of options may cause focus on the short-term in periods in which it is
more profitable to do so. If shareholders have a short-term focus, then they, too, may benefit from
encouraging management to focus on the short-term, especially in periods of speculation (Bolton,
Scheinkman, and Xiong (2003)).
We compare restating firms and non-restating firms in the S&P 1500, over the period
from 1994-2002. Our contribution is in examining the personal incentives that CEOs have in
relation to their compensation to make aggressive accounting choices. In particular, we examine
equity-linked compensation: options, stock holdings, restricted stock and long term incentive
plans, as these are more likely to cause managers to focus on stock price. We find that the
sensitivity of compensation from options, as measured by the change in value of the option for a
percentage change in stock price (delta), is greater in restated firm-years than non-restated firm-
years. This provides evidence consistent with the hypothesis that incentives from option
compensation encourages misreporting that results in restatement. We also examine the effect of
the convexity of the CEO’s option portfolio, by examining gamma (the second derivative of the

3
See Sloan (1996); also Teoh, Welch and Wong (1998) for information on how accruals affect price.
5

option with respect to stock price) because the delta of the option does not directly take into
account the convexity of an option. Misreporting may be more likely when there is a larger
change in the value of options for a change in the stock price, as captured by gamma. We find
that misreporting is more likely when the convexity is greater.
In contrast to options, equity and restricted stock performance have a symmetric relation
to the stock price; thus, the downside risk of using aggressive accounting is greater for these
relative to options. However, aggressive accounting may still be beneficial to equity holdings if
managers can sell before a decline in the stock price. Restricted stock and long-term incentive
plans (LTIPs) may also reduce incentives to use aggressive accounting because they make
executive compensation a function of longer-term firm value. We did not find evidence to support
the hypotheses that LTIPs and restricted stock reduce the propensity to misreport. This may be
due to the smaller portion of compensation that long-term incentive plans and restricted stock
have relative to other compensation. We find that equity holdings do not encourage misreporting
to the extent that options do.
We examine whether restating firms have ‘abnormal’ equity incentives. We estimate
‘normal’ or optimal incentives using Core and Guay’s (1999) model of the CEO’s optimal equity
incentives, a model that estimates equity incentives from theoretically and empirically motivated
factors. We estimate abnormal option and stock incentives as the deviation of the firm equity
incentives from optimal incentives. We find significantly abnormal incentives from option
compensation in restated years.
We test the implication from the Bolton, et. al. (2003), that managers are more likely to
use aggressive accounting in periods in which it is most profitable to do so. We find weak
evidence consistent with this, finding that restated years were more likely in 1998 and 1999,
6

periods with inflated market valuations. However, an aggregate market valuation measure does
not explain restatements.
Finally, we examine whether the market reacts differently to firms based on the CEO’s
exercise of options during the time of alleged manipulation. If options provide the camouflage
suggested by the rent extraction view, then the market will under-react to the exercise of options

in the periods which had to be restated. We find the announcement reaction is more negative for
firms with greater exercise activity in those periods, providing evidence that options provide the
camouflage suggested by proponents of the rent extraction view.
We also examine how restating firms differ from non-restating firms with regards to
characteristics identified in other studies. We find evidence that restating firms have higher
leverage and greater market valuations than non-restating firms in the S&P 1500. We find that
restating firms use discretionary accruals more aggressively than non-restating firms in the first
year that had to be restated, confirming similar results in Richardson, Tuna and Wu (2002).
However, we do not find that their use of accruals is significantly greater in the years leading to
the restatement.
The organization of the paper is as follows: Section 2.2 provides a primer on
restatements. Section 2.3 reviews literature on compensation, and develops hypotheses. Section
2.4 introduces and reports characteristics of our sample; Section 2.5 describes the measurement of
key variables. Section 2.6 presents analysis of factors that may enhance or mitigate incentives to
engage in aggressive accounting that may lead to restatements. Section 2.7 presents analysis of
the market reaction. Section 2.8 concludes.

2.2. A primer on restatements.
A restatement is a firm’s admission to the fact that its accounting statements are not in
conformance with Generally Accepted Accounting Practices (GAAP). They are generally
7

associated with a strong market reaction at the time of announcement, although speculation that a
firm might have to restate is often in the news before the announcement of the restatement
(Palmrose, Richardson and Scholz (2001)). While restatements can be filed due to a change in
accounting practices, merger and acquisition, stock split, or one-time error, we exclude these
from analysis, because they are not the result of purposeful accounting practices outside of GAAP
and are generally not associated with significant market reactions (Palmrose, et. al., (2001)).
When a firm restates, it may restate one or more financial statements previously filed with the
SEC. These may be previously filed 10-Qs or 10-Ks.

A restatement involves the misreporting of an item (or number of items) on a financial
statement. An example of misreporting involving revenue recognition is as follows:
Xerox improperly recognized $1.5 billion in pretax earnings over
the 1997 to 2000 fiscal years, by recording revenue from lease
contracts immediately, as opposed to over the life of the contracts.
4


The use of aggressive accounting can be used, as in the Xerox example, to increase
revenue in a particular period by recording revenue too soon. However, in times when earnings
are good, management may also choose to set aside reserves- that is, recognize revenue in later
periods rather than the current period. This may be accomplished by taking larger than needed
one-time charges.
5

One can see the similarities between the above example and the use of accruals in which
revenues might be shifted forward (reversed) and expenses delayed (forward).
6
As a
spokeswoman for Xerox, Christa Carone, said regarding the revenue recognition, “It’s just going
from one place (in Xerox’s books) to another”.
7
However, the use of accruals does not lead to

4
Gilpin, K., S.E.C Accuses Xerox of Accounting Abuses, The New York Times, April 12, 2002.
5
An example of a firm using aggressive one-time charges is CUC/Cendant where the firm took larger than
needed one-time charges, used later to create fictitious income (see Schilit (2002)).
6

See Teoh, Welch, and Wong (1998).
7
Rayner, A., Xerox overstated revenues by $6.4bn, The Times, June 29, 2002.
8

restatements as they occur within the confines of GAAP. The previous examples violate GAAP
and therefore, when identified, result in a restatement. Thus, the study of restating firms is useful
in evaluating whether mode of compensation gives incentives to managers to make aggressive
accounting choices because it is less questionable that these are aggressive choices.
Implicit in the arguments that aggressive accounting can be used to affect stock price is
the assumption that manipulative accounting fools the market. The large impact of a restatement
on firm value is an indication of the fact that the market was not able to sort out the aggressive
accounting. Moreover, it is hard to argue that the market appropriately adjusted Enron, Qwest and
Worldcom’s stock prices for their undisclosed debt, swap-like sales
8
and other forms of
misreporting. Given that the market uses accounting information to infer firm valuation and given
the link between a manager’s compensation and stock price performance, it is reasonable to
investigate the relation between compensation and accounting choices.

2.3 Literature review and development of hypotheses.
2.3.1 The effect of option compensation.
Adoption of performance-sensitive compensation plans and the adoption of stock option
plans are often greeted positively by the market (Morgan and Poulsen (2001)). This is attributed
to the idea that it is necessary to tie management’s wealth to shareholder wealth (Jensen and
Meckling (1976)) in order to reduce agency conflicts. The dependence of a manager’s wealth on
firm performance causes uncertainty in management’s compensation. As a result, risk-averse
management may forgo risky projects. Smith and Stulz (1985)) assert that stock options may be
used to mitigate the effects of risk-aversion by making a manager’s compensation a convex

8
A swap sale occurs when two firms in similar industries swap the use of a revenue generating asset. For
instance, in the telecom industry, firms might swap the use of phone network connections. This allows each firm
to record revenue. See Berman, D., J. Angwin and C. Cummins, As the Bubble Neared its end, Bogus Swaps
Padded the books. The Wall Street Journal, Dec 23, 2002.
9

function of firm value. Thus, traditionally, options are viewed as an influential means to align
manager’s interest with shareholders by inducing management to take on more positive net
present value risky projects.
The assumption that options are used solely to align the interests of management with
shareholders has come under scrutiny with the increase in the number of restatements by large
firms. Bebchuk, Fried and Walker (2001), proponents of the rent extraction view, argue that
options enable management to extract rents in the form of excessive compensation. Especially
important to the ability of management to extract rents is their ability to make it less identifiable
that rent extraction is taking place.
A camouflaging feature of options, introduced by Bergstresser and Philippon (2002), is
that they enable managers who are exercising stock options in order to take advantage of
information asymmetry to pool with those exercising stock options for liquidity reasons.
9

Bebchuk and Bar-Gill (2003) argue that the ability of management to take advantage of
information asymmetry depends on the amount of shares that managers may sell relative to the
number of shares that management would be able to sell for liquidity purposes (or diversification
purposes). Since managers tend to sell the equity acquired through stock options (Ofek and
Yermack (2000)) as they vest, then managers who are manipulating can pool themselves with
managers who are selling options for liquidity reasons. If the market is unable to undo the
aggressive accounting during the periods in which managers are selling, then managers benefit
from selling at a price that is higher than it would be otherwise.
It is important to remember that a manager’s utility from holding options increases with

the stock price even if they are not planning to immediately exercise (Core and Guay (1999)).
The potential for options to increase wealth comes from their sensitivity to the underlying stock

9
Consistent with this hypothesis, they find that managers exercise more options in periods with greater
discretionary accruals.
10

price. Gao and Shrieves (2002) find that earnings management intensity is significantly and
positively associated with the sensitivity of the CEO’s option portfolio to stock price. While, they
attribute this to the manager’s attempt to exploit the non-linearity in the payoff of option
compensation, they do not test for this empirically.

H1: Aggressive accounting associated with restatements is more likely in firms in which
executives have more wealth affected by options.

If managers who take advantage of information asymmetry are pooled with those
exercising for liquidity reasons, then the market will not react significantly to the exercise of
options in the manipulated period. Thus, the announcement reaction to the restatement will be
related to the aggregate amount of exercise activity of executives during the period of alleged
manipulation. That is, the market will not have incorporated into the stock price, at the time of
manipulation, the exercise of options that occurred in the misreported years. This argument rests
on the assumption that other information is released during the misreported year that is consistent
with the financial statements that are misreported at fiscal year end.
10
If the aggressive accounting
continues to work after the release of the misreported financial information, then we expect the
exercise activity to continue until the announcement of the need for restatement, so we also look
at the subsequent year.

H2: The announcement reaction to a restatement is related to the exercise activity of
executives in the period for which misreporting occurred.


10
For instance, quarterly financial numbers should approximately add up to annual numbers.
11

Bolton, Scheinkman and Xiong (2002) model a world in which rational current
shareholders want management to maximize the short-term stock price, even at the expense of
long-term fundamental value. In this model, there exists a speculative market in which a subset of
investors is overly optimistic. This creates an option-like feature for incumbent shareholders- one
in which they can sell to the new “gullible” shareholders.
11
As a result, in a speculative market,
incumbent shareholders compensate managers in such a way as to increase their focus on
maximizing stock prices in the short-term, even at the expense of long-term value. Bolton et. al.
(2003), argue that shareholders do this by granting stock options that are easier to sell, allowing
executives to sell shares to overoptimistic investors within the laws of insider trading. In contrast
to the rent extraction view, managers are not exploiting information asymmetry with rational
shareholders for their own benefit, but are induced by their compensation structure and the
speculative components of the stock market. In this way, executive’s interests are aligned with a
subset of investors- those with a short-term horizon who wish to focus a manager’s attention to a
particular time.
The Bebchuk and Bar-Gill (2003) model also has implications for the timing aspects of
misreporting. Their model implies that the relative weight the market puts on future estimated
growth versus current cash flows enables firms to have more opportunity to benefit from
misreporting. This may be more likely to occur in periods of speculation, or excessive optimism
by the market. They also conclude that misreporting is more likely to occur when executives have
more shares that they can sell in a particular period. This is likely to coincide with the number of

exercisable options, as these can be sold under the guise of liquidity purposes, as described
earlier.

11
More specifically, firm value is the sum of its fundamental value plus a project that may be overvalued in a
speculative market. Rational investors price the probability of short -term profits from selling to irrational
investors- a speculative component of the firm’s stock price. Managers are encouraged to exploit the irrational
investors.
12


H3: Aggressive accounting is more likely to occur during speculative periods, or in
periods with higher market valuations.
H4: Aggressive accounting is more likely when managers have a greater number of
vested options.

2.3.2. Convexity.
It is well known that stock options add convexity to the relation between the manager’s
wealth and stock price. The convexity refers to the curvature of the wealth performance
relationship (Guay (1999)) while the sensitivity of the CEO’s compensation to stock price is the
slope. Because of the convex payoff structure provided by options, changes in firm value will
lead to changes in incentives, where incentives are measured by delta (the derivative of the option
value with respect to the stock price).
12
That is, at different values of the firm, incentives for
managers to increase the stock price will be greater.
Moreover, the asymmetric payoff structure of options mitigates a negative wealth effect
in the event of a stock price decline. If managers engage in aggressive accounting, and that
aggressive accounting has the effect of causing the stock price to increase, then both shareholders
and managers will benefit. If the aggressive accounting stops working, management will be less

affected by the decline in share price than if their exposure had been through stock holdings.
13

Therefore, options partly insulate managers from the negative effects of their discretion.
14
We

12
Delta is greater when options are in-the-money than when the options are out-of-the money, holding all else
constant (Hall (1999)).
13
Moreover, if market sentiment changes unexpectedly so as to cause the aggressive accounting to stop working,
management can still benefit during the price decline as long as they exercise while the strike is lower than the
current price. For some firms, many options have been issued years ago at much lower strike prices than current
prices, making this a possibility.
14
The Sarbanes-Oxley Act of 2002 attempts to address these concerns, forcing managers to pay back incentive
based compensation earned during the 12 month period following the filing of a financial statement that had to
be restated (Section 304).
13

expect that managers will be more likely to misreport when incentives are more sensitive to stock
price, as measured by gamma (the second derivative of the option with respect to stock price).
15,16


H5: Aggressive accounting is more likely to occur when a small change in price causes a
larger change in incentives or when convexity is greater.

In contrast to options, we expect that performance-sensitive compensation with a

symmetric payoff structure will reduce the incentive to use aggressive accounting. With a
symmetric payoff structure, a CEO may be less likely to engage in aggressive accounting,
because the downside risk on CEO compensation is greater. Both the executive’s stock holdings
and restricted stock have a linear payoff with respect to the stock price. Because of its linear
relationship with the stock and its restrictions imposed by vesting requirements, restricted stock
may intensify executives aversion to risk taking, even more so than stock (Bryan, Hwang and
Lillien (2000)).
Both restricted stock and equity may also increase the manager’s time horizon relative to
the short-term focus encouraged by options. Restricted stock increases the manager’s time
horizon due to vesting restrictions, while equity increases the time horizon because it does not
offer the ease of selling that options do (Bebchuk et. al., (2002), Bergstresser and Philippon
(2002)). Shleifer and Vishny (2002) describe the importance of a manager’s time horizon,
suggesting that managers might want to “get out” of their ownership positions due to closeness to
retirement, ownership of stock options or desire to cash-out while market valuations are high.

15
Jensen (2001) finds evidence that non-linear payoff structures provide incentive to manipulate accounting
profits. When far from a performance threshold, incentives to reach that target are diminished; when close to it or
above the target, incentives are greater. If manipulation of accounting statements affect prices, then in the context
of equity compensation, non-linearities will induce similar behavior.
16
Previous studies measure convexity as the derivative of the option value with respect to volatility (Vega).
However, Vega measures incentives to increase volatility. We focus on incentives to increase price.