Financial Misrepresentation, Executive Compensation, and Firm Performance: an Empirical Study

Financial misrepresentation has serious, detrimental economic and social impacts. We present hypotheses regarding the factors that incline a firm to misrepresent its finances. Using a matched sample design, we find that three factors increase a firm’s probability of misrepresenting its financial position: performance below its industry’s average performance, performance significantly above its own past performance, and its CEO receiving a high proportions total compensation as stock options. CONCEPTUALIZING CORPORATE MISCONDUCT This paper examines the factors that encourage firms to engage in one specific form of corporate misconduct – misrepresentation of its financial position. Revelations of financial misrepresentation often result in ruinous corporate economic outcomes, and damage to stakeholders (employees, customers, suppliers, etc.). In addition, such misconduct can have a detrimental societal impact, both by damaging many stakeholders and by damaging institutions that rely on accurate reporting. We operationalize financial misrepresentation as financial restatements for accounting irregularities. Although firms often restate their financials for non-controversial reasons (e.g., stock splits, mergers, or formal changes in accounting methods), accounting restatements also arise from material errors and misrepresentations, termed ‘irregularities’. The Government Accountability Office (GAO) defines ‘irregularities’ as any “instance in which a company restates its financial statements because they were not fairly presented in accordance with generally accepted accounting principles (GAAP)”, including material errors and fraud (GAO, 2002:2). Many well-known corporate misbehaviors of recent years included an element of financial misrepresentation. We analyze a sample of restatements based on accounting ‘irregularities’ announced between January 1, 1997 and June 30, 2002.