Home | Business News | Browse by Publication | E | Economic Inquiry

Managers' compensation and misreporting: a costly state verification approach.

Article Excerpt
I. INTRODUCTION

The use of stock options in compensation packages as a way of providing the firm management with the right incentives has been quite popular in the 1990s. The favor encountered by options started, however, to decrease in the past few years. The decline in the use of option grants in top executives' compensation packages occurred mainly as a reaction to the recent accounting scandals, which has prompted the design of alternative stock-based compensation schemes (e.g., restricted stock grants or indexed options).

As reported by Hall and Murphy (2003), the grant date value of options assigned to all employees of an average Standard & Poor's 500 firm, measured in millions of 2002 constant US$, increased from 22 in 1992 to 238 in 2000 and subsequently decreased to 141 in 2002. Although percentages varied from year to year, the CEOs' share of the total grant has fallen from about 7% in the mid-1990s to less than 5% in 2000-2002. (1) The decline in the use of options for top management is widely confirmed. According to a Pearl Meyer & Partners study for the New York Times, stock option grants that accounted for 52% of the pay of the average CEO of a major company in 2002 were down to an estimated 35% in 2003. A recent Watson Wyatt report states that the value of new stock option awards granted to CEOs at large companies fell by nearly 60% between 2001 and 2003, with the average value of new stock option grants declining from US$ 10.2 million in 2001 to US$ 4.2 million in 2003. The decline in options has been softened by the sharp increase in restricted stock grants and other long-term incentive award values. (2)

In this paper, we aim to reevaluate the role of stock options as an ingredient of top management compensation packages, able to align the interests of managers and shareholders, avoiding misreporting of the firm value at the same time. (3) In a "costly state verification (CSV) model with moral hazard, we show that incentive-compatible contracts, inducing both incentive alignment and truthful revelation of the firm value, must entail a (strictly) convex compensation schedule, that is, a fixed payment (wage) when the firm value is sufficiently low and a state contingent claim, increasing in the firm value, otherwise.

A simple and commonly observed way to achieve a convex compensation scheme is to design a remuneration including a fixed wage and a call option on the firm equity. As we will show, such remuneration allows on the one hand to preserve top management incentives (providing for a compensation increasing in equity value) and on the other hand to reduce the verification costs that must be incurred to avoid misreporting (as verification is not needed in the region where the remuneration is fixed). (4) Options are by no means the only way to achieve a convex compensation. However, many other schemes, having otherwise desirable properties over options, do not have the convex shape discussed above. For instance, combining a fixed wage with (restricted) stock grants defines a compensation--linearly increasing in the firm's (equity) value--which does not allow to reduce misreporting verification costs that always have to be sustained in this case.

Using an incentive-compatible compensation scheme (fixed wage plus call options), we characterize the contract offered by the firm under the assumption of a deterministic and perfect audit technology showing that, for any given value of the option package, the manager should receive the largest possible number of options at the highest strike price, allowing shareholders to reduce the expected verification cost. Furthermore, the strike price of the option turns out to be determined by incentive compatibility (i.e., the option value must be such that the manager is induced to exert the desired level of "effort"), while the magnitude of the fixed wage is defined by individual rationality.

There are three main policy implications of our analysis. First, the current tendency of dismissing option plans in favor of other instruments is not necessarily well posed, as the use of stock options may contribute to reduce the costs of aligning shareholders' and managers' interests. Second, since it is well known that audit resources are scarce, our model suggests that the audit activity should be selective, focusing especially--although obviously not exclusively--on the cases in which top executives exercise their options (thus giving weight to the threat of misreporting detection). Third, the same logic can be extended to the supervision of audit firms, suggesting that inspectors should pay special attention to the reports of the audit firm under scrutiny when the top management of the auditee clients benefits from substantial payments through stock-based compensation.

Overall, this paper provides two contributions. On normative grounds, it suggests that firms might be overreacting to accounting scandals. The way out from accounting frauds should not necessarily rely on abandoning stock options--giving up their incentive alignment positive effects--but rather on improving the design of the audit activity (together with the supervision on the audit sector). On the positive side, it suggests a possible explanation of why so many firms have dismissed stock option plans in recent years (and are still doing so), underlying that the exercise of options by top managers has not been properly monitored by auditors.

The paper is organized as follows. Section II reviews theoretical and empirical contributions related to ours. Section III defines our setup, determines the characteristics of incentive-compatible compensation schemes, and illustrates the optimal contract. Section IV focuses on the policy implications of our contract design strategy. Section V summarizes and concludes.

II. RELATED LITERATURE

A. Executive Compensation Theory and the CS V Approach

Only recently the literature on managers' compensation has begun to deal with the interplay between performance-based payments and misreporting. Our work bears some similarities with Goldman and Slezak (2006): they explicitly examine the trade-off between inducing high effort and creating incentives to misreport, finding that the optimal contract between shareholders and managers might not be completely free from cheating. Their analysis is, however, restricted to linear payment schedules--like a fixed wage plus some stocks. Dye (1988) points to the need of accepting some degree of accounting distortion in order to preserve the effort incentive properties of managers' compensation. Furthermore, Stoughton and Wong (2006) attribute to stock options the undesirable feature of inducing "conservative accounting" (i.e., building up reserves on the balance sheet in good times and drawing them down in bad times in order to meet analysts' expectations).

A related issue is the determination of the optimal strike price for executives' stock options. Hall and Murphy (2000) show that the valuation problem must be carefully considered. There is a wedge between the cost to a firm of a nontradable stock option--which may be computed by using the standard Black-Scholes formula and its value (and incentive properties) for a risk-averse manager: the latter being lower than the former. (5) Taking this problem into account, they find that the effort-inducing property of a stock option is maximized when the strike price is set close to the grant date market price, justifying the practice of issuing at-the-money executive options. By extending this approach for considering effort aversion as well, Palmon et al. (2004) find that in-the-money options should be preferred--except for tax-related disadvantages. Although our model does not explicitly account for the value of the firm's...

View this article FREE - Now for a Limited Time, try Goliath Business News
Free for 3 Days!