This paper examines the effect of CEO compensation contracts on misreporting. We find that the sensitivity of the CEO's option portfolio to stock price is significantly positively related to the ...propensity to misreport. We do not find that the sensitivity of other components of CEO compensation, i.e., equity, restricted stock, long-term incentive payouts, and salary plus bonus have any significant impact on the propensity to misreport. Relative to other components of compensation, stock options are associated with stronger incentives to misreport because convexity in CEO wealth introduced by stock options limits the downside risk on detection of the misreporting.
We find that firms grant more rank and file stock options when involved in financial reporting violations, consistent with managements’ incentives to discourage employee whistle-blowing. Violating ...firms grant more rank and file options during periods of misreporting relative to control firms and to their own option grants in non-violation years. Moreover, misreporting firms that grant more rank and file options during violation years are more likely to avoid whistle-blowing allegations. Although the Dodd-Frank Act (2010) offers financial rewards to encourage whistle-blowing, our findings suggest that firms discourage whistle-blowing by giving employees incentives to remain quiet about financial irregularities.
Explaining the Diversification Discount Campa, Jose Manuel; Kedia, Simi
The Journal of finance (New York),
August 2002, Volume:
57, Issue:
4
Journal Article
Peer reviewed
Open access
This paper argues that the documented discount on diversified firms is not per se evidence that diversification destroys value. Firms choose to diversify. We use three alternative econometric ...techniques to control for the endogeneity of the diversification decision, and find evidence supporting the self-selection of diversifying firms. We find a strong negative correlation between a firm's choice to diversify and firm value. The diversification discount always drops, and sometimes turns into a premium. There also exists evidence of self-selection by refocusing firms. These results point to the importance of explicitly modeling the endogeneity of the diversification status in analyzing its effect on firm value.
This paper examines the prevalence of informed trading in corporate bonds prior to takeover announcements. We find significant pre-announcement trading activities and price movements in target bonds, ...in directions consistent with the nature of pending information. Improved transparency in the bond markets achieved by the implementation of the Trade Reporting and Compliance Engine (TRACE) system reduces the incidence of informed trading. Further, there is some weak evidence that dealers affiliated with merger and acquisition advisors sell in anticipation of negative news, pointing to a possible channel of information leakage. Such negative news seems to be incorporated into bond prices no slower than into the target stocks.
•We examine the prevalence of informed trading in corporate bonds before takeover announcements.•We find a price run-up/decline in target bonds that stand to gain/lose during the pre-announcement periods. This finding suggests the role of information.•Improvements on market transparency reduce the incidence of informed trading in bonds.•Bond dealers affiliated with M&A advisors tend to sell more of the bonds that stand to lose.•Negative news is incorporated into bond prices no slower than into the target stocks.
We study fund-firm connections that arise when firm executives and directors serve as fund directors. We find that connected funds are significantly more likely to vote with management in proposals ...with negative Institutional Shareholder Services (ISS) recommendations or low shareholder support. As our data show that management support does not exist either before connection formation or after its termination, this result is unlikely to be caused by omitted factors. Rather, the connected fund's voting patterns show independence from ISS recommendations and successful connected voting is associated with positive announcement returns, suggesting that connected fund support for management reflects information advantages. Lastly, we find that a fund family and firm are more likely to connect when the fund family holds a large stake in the firm and is geographically proximate as well as when it has a record of voting independently from ISS.
The Economics of Fraudulent Accounting Kedia, Simi; Philippon, Thomas
Review of financial studies/The Review of financial studies,
06/2009, Volume:
22, Issue:
6
Journal Article
Peer reviewed
Open access
We argue that earnings management and fraudulent accounting have important economic consequences. In a model where the costs of earnings management are endogenous, we show that in equilibrium, ...low-productivity firms hire and invest too much in order to pool with high productivity firms. This behavior distorts the allocation of economic resources in the economy. We test the predictions of the model using firm-level data. We show that during periods of suspicious accounting, firms hire and invest excessively, while managers exercise options. When the misreporting is detected, firms shed labor and capital and productivity improves. Our firm-level results hold both before and after the market crash of 2000. In the aggregate, our model provides a novel explanation for periods of jobless and investment-less growth.
Recent frauds have questioned the efficacy of the SEC's enforcement program. We hypothesize that differences in firms' information sets about SEC enforcement and constraints facing the SEC affect ...firms' proclivity to adopt aggressive accounting practices. We find that firms located closer to the SEC and in areas with greater past SEC enforcement activity, both proxies for firms' information about SEC enforcement, are less likely to restate their financial statements. Consistent with the resource-constrained SEC view, the SEC is more likely to investigate firms located closer to its offices. Our results suggest that regulation is most effective when it is local.
► We hypothesize that differences in firms' information sets about SEC enforcement and constraints facing the SEC affect firms' proclivity to adopt aggressive accounting practices. ► We find that firms located closer to the SEC and in areas with greater past SEC enforcement activity, both proxies for firms' information about SEC enforcement, are less likely to restate their financial statements. ► Consistent with the resource-constrained SEC view, the SEC is more likely to investigate firms located closer to its offices. ► Our results suggest that regulation is most effective when it is local.
We examine contagion in earnings management using 2,376 restatements announced during the years 1997–2008. Controlling for industry and firm characteristics, firms are more likely to begin managing ...earnings after the public announcement of a restatement by another firm in their industry or neighborhood. Such contagion is absent when the restating firm is disciplined by the SEC or class action lawsuits, suggesting deterrent effects of enforcement activity. Contagion among peers is observed (1) in the same account as the one restated by the target firm, or (2) when larger target firms restate or the restatement is prominently disclosed, or (3) when the target firm's restatement is less severe. Contagion stops during the years 2003–2005, possibly due to the enforcement associated with the Sarbanes-Oxley Act (SOX), but reappears during 2006–2008, perhaps because the sting associated with SOX has worn off. In sum, peers' actions appear to affect a firm's earnings management decisions.
We investigate a prominent allegation in congressional hearings that Moody's loosened its rating standards to chase revenue after it went public in 2000. Consistent with this allegation, Moody's ...ratings for both corporate bonds and structured finance products are significantly more favorable to issuers, relative to S&P's, after Moody's IPO. Moreover, Moody's ratings are more favorable for clients subject to greater conflict of interest. There is little evidence that Moody's higher ratings, post-IPO, are more informative, measured as expected default frequencies (EDFs) or as the probability of default. Our findings inform the debate on whether financial gatekeepers should be publicly traded.
We find that the likelihood and severity of financial misreporting is positively related to aggregate institutional ownership and this effect can be largely attributed to ownership by institutions ...with short investment horizons — those with little incentive to engage in costly monitoring of firm activities and precisely those that sell at the announcement of a restatement. We also find that the concentration of holdings by these institutions offsets this effect, which suggests concentrated ownership induces greater monitoring and mitigates the incentives for firms to misreport. Our results suggest that any link between myopic firm decision making and institutional ownership may be related to the nature of institutional monitoring.
PDF
