Do Ceo Stock Options Prevent or Promote Fraudulent Financial Reporting

DO CEO STOCK OPTIONS PREVENT OR PROMOTEFRAUDULENT FINANCIAL REPORTING?

JOSEPH P. O’CONNOR, JR.University of Texas at El Paso

RICHARD L. PRIEMUniversity of Wisconsin–Milwaukee

JOSEPH E. COOMBSTexas A&M University

K. MATTHEW GILLEYOklahoma State University

We contrast the conventional view that CEO stock options aid corporate governance byreducing moral hazard with the proposal that CEO stock options may subvert soundcorporate governance. Views were tested in 65 matched pairs of public U.S. firms thateither had or had not been discovered misreporting financial results. Our resultssupport both the traditional perspective and our unprincipled agent view: in oursample, large CEO stock option grants were sometimes associated with a lower inci-dence of fraudulent reporting and sometimes with a greater incidence, depending uponwhether CEO duality was present and whether directors also held stock options.

Accurate financial reporting by listed firms isessential for viable equity markets. Yet recently,fraudulent financial reports have damaged theU.S. economy, contributing to $7 trillion lost byU.S. pension plans and 401(k) savings plans from2000 to 2002 (Siebert, 2002). These intentionalfinancial misstatements by corporate manage-ments have led some scholars to question thelegitimacy of shareholder return as the core valuegoverning corporations and to argue instead forapproaches that maximize other stakeholder ben-efits or aggregate societal welfare (Child, 2002;Kochan, 2002). Others, however, continue to fo-cus on shareholder return, searching for effectivecorporate governance mechanisms that minimizemoral hazard in the management-shareholderrelationship.

Unethical or illegal behavior, particularly thatinvolving financial reporting, erodes shareholdervalue. Sound corporate governance thereforemust include, at the very least, the decision toeschew fraud in financial reporting. But manage-

ment research has yet to link even widely pre-scribed governance mechanisms with this mostbasic decision: to strive to report financials accu-rately. Stock option grants to CEOs are one ac-cepted corporate governance mechanism that,along with appropriate monitoring, should in-duce CEOs to make decisions consistent withlong-term shareholder wealth maximization (Be-atty & Zajac, 1994). Yet a key governance issueremains: how do CEO stock option grants influ-ence firms’ subsequent likelihood of malfeasancein financial reporting?

In this article, we first discuss several agencytheory (Jensen & Meckling, 1976) prescriptionsfor corporate governance that are intended to pre-vent or minimize harm to shareholders. Second,we argue that prescriptions for CEO and board ofdirectors stock options can, when carried to ex-tremes, promote harmful behavior by unprinci-pled agents. Third, we develop a model that con-trasts agency theory’s incentives alignment logicwith options-based temptations for unprincipledagents, in the context of financial reporting accu-racy. Fourth, we report tests of our model using amatched-pairs analysis of firms that did and didnot engage in fraudulent financial reporting. Fi-nally, we discuss the implications of our resultsfor practitioners and scholars interested in cor-porate governance.

We thank Paul Clikeman, Tim Haas, David North, PaulNystrom, Ehsan Soofi, and the members of the Universityof Wisconsin–Milwaukee Doctoral Seminar in Organiza-tion Theory for helpful comments on earlier versions ofthis article, and Jeff Vanevenhoven for data-gatheringassistance.

� Academy of Management Journal2006, Vol. 49, No. 3, 483–500.

483

THEORETICAL BACKGROUND

Early studies of corporate illegal activity, whichthey labeled “white-collar crime,” focused on indi-vidual business people who bribe, embezzle, ormisappropriate funds, manipulate stock exchanges,misrepresent financial statements, misleadinglyadvertise, and so on (Sutherland, 1940; Tappan,1947). Later white-collar crime studies emphasizedillegal acts committed for corporate gain ratherthan individual gain (e.g., Sutherland, 1956). Morerecent studies have distinguished between corpo-rate and individual criminality by identifying thebeneficiaries: companies benefit from corporatecrimes, while individuals achieve personal gainthrough individual crimes (Baucus, 1994; Daboub,Rasheed, Priem, & Gray, 1995; McKendall & Wag-ner, 1997; Schrager & Short, 1978).

The various well-known corporate financialfrauds that occurred in the United States in theearly 2000s generally involved inaccurate or mis-leading financial statements intended to maintainthe appearance that a company continued to gen-erate high earnings. The specific techniques varied:“serial acquirers” manipulated postacquisitionearnings with each purchase; trading companiesengaged in “round tripping” to boost revenues;some firms used “off-balance-sheet” entities for fi-nancing; and so on. The consistent goal, however,was to meet Wall Street expectations and therebykeep stock prices high. This contrived elevation ofstock price benefited executives in the near term bycalming performance pressure and, often, by allow-ing the sale of stock options at artificially inflatedprices. In many cases, the firms themselves wereobvious victims, ultimately filing for bankruptcy toavoid liquidation after their stock prices finallycrashed. Employees, their 401(k)s and pensionfunds, local communities, and investors all alsosuffered. Clearly, these frauds failed to benefit thefirms involved, but they often instead rewardedindividual top managers, many of whom shared acommon possession: large blocks of stock optiongrants that could be exercised in advance of nega-tive information.

Principal-Agent Theory and Moral Hazard

Berle and Means’s (1932) seminal study of thelargest 200 U.S. public corporations highlighted theseparation between shareholders, who supply cap-ital and bear risk, and managers, who control firms.They aptly noted that the struggle for corporatecontrol revolves around the desire for personalgain. Differing viewpoints subsequently have de-veloped concerning (1) the status of shareholders as

firm owners and (2) the proper role of a firm’s boardof directors. Some researchers (Berle & Means,1932; Jensen & Meckling, 1976) have viewed share-holders as owners. Others (Alchian & Demsetz,1972; Fama, 1980) have seen shareholders as inves-tors rather than owners, because others alreadyown firms’ resources through the nexus of individ-ual contracting relationships that comprise eachfirm (Coase, 1937). Shareholders as investors ben-efit through limited liability, unrestricted share sal-ability, and voting authority in ways owners wouldnot (Alchian & Demsetz, 1972). Similarly, althoughBerle and Means (1932) saw directors as membersof management serving in a fiduciary capacity,other scholars (Finkelstein & Hambrick, 1996) nor-matively viewed board members as agents for firm-specific resource owners such as shareholders,creditors, employees, and customers. Nonetheless,consensus has developed concerning the centralrole of moral hazard in corporate governance issues(Foss, 1996a).

Moral hazard occurs when managers, acting asagents for shareholders, behave in ways that re-duce shareholder value (i.e., are against the prin-cipals’ interests). Arrow (1971a) likened equityownership to a managerial insurance policy, be-cause equity distribution allows managers toshift some of their firms’ risk to shareholders.Arrow (1971b) then extended the insurance in-dustry’s concept of moral hazard—wherein aninsurance policy can induce undesirable behav-iors, such as insuring real estate assets inamounts that exceed their value and then com-mitting arson—to the situation of corporate con-trol. Some major categories of executive moralhazard cited in the literature include asset expro-priation by selling below market rates (Shleifer &Vishny, 1997); misstatements and nondisclosuresthat place nonmanagement shareholders at a dis-advantage (Berle & Means, 1932); consumption ofcostly perquisites (Jensen & Meckling, 1976); pur-suit of personal objectives, such as increasedcompensation, through diversification andgrowth ventures that misuse free cash flow(Jensen, 1986); foregoing investments in projectsthat have positive net present values, to avoid therisk of unemployment if the projects fail (Denis,2001; Finkelstein & Hambrick, 1996); and ex-traordinary efforts to remain in power by fightingtakeover attempts that might benefit shareholders(Shleifer & Vishny, 1997). In the face of thesepossibilities for moral hazard, one of principal-agent theory’s key contributions has been its pre-scriptions for effective corporate governance.

484 JuneAcademy of Management Journal

Corporate Governance

Corporate governance attempts to mitigate moralhazard problems. Jensen (1993) argued that fourforces operate to promote effective governance: le-gal and regulatory systems; external control mech-anisms, such as capital markets, that allow compa-nies to be taken over; product and factor markets;and internal control systems headed by boards ofdirectors. Legal and regulatory systems includemonitoring in the form of external regulatory over-sight as well as bonding through debt and bank-ruptcy. External control mechanisms encompassthe capital markets’ ability to handle liquidationsand takeovers, the ultimate discipline for failure tomaximize shareholder value (Fama, 1980). Productand factor markets include competition for firms’products and services and the discipline of theexternal and internal managerial labor markets (Al-chian & Demsetz, 1972; Fama, 1980). Internal con-trol systems encompass board activities, plus exec-utive compensation, stock options, and ownershipinterests, all intended to align managers’ desire forpersonal gain with the similar motivation of share-holders (Denis, 2001; Jensen & Meckling, 1976;Shleifer & Vishny, 1997).

HYPOTHESES

We focus on CEO incentive compensation, in theform of stock option grants, as a major element ofthe corporate control system, because (1) incentivecompensation often is seen as a vital component ofsound corporate governance systems (Denis, 2001;Jensen & Murphy, 1990); (2) stock options are verycommon for CEOs (Knight, 2002); (3) CEOs are keyactors whose perceptions and actions influencetheir firms’ capabilities and, ultimately, firm-levelperformance (e.g., Daft, Sormunen, & Parks, 1988;Priem, 1994); (4) the value of other top executives’stock options incentives is often linked to the valueof their CEO’s stock options; and (5) CEO stockoptions are visible to all firm stakeholders throughpublic records, such as the firm’s proxy statement,and thereby can represent a concrete signal forstakeholders that the goal of the firm’s CEO is in-creasing shareholder value. We first develop com-peting hypotheses concerning the potential effectsof CEO stock option compensation on the likeli-hood of fraudulent financial reporting. We thensuggest that the strength of these effects is en-hanced when either CEO duality1 or board stock

option compensation is also present, and that thisenhancement is greatest when both occursimultaneously.

Two Views of Incentive Compensation andFraudulent Financial Reporting

Jensen and Meckling (1976) introduced the no-tion of aligning managers’ interests with those ofshareholders, and thereby reducing moral hazard,through the use of incentive compensation. Such“outcome-based” incentive contracts shift risk fromshareholders to management (Arrow, 1971a; Eisen-hardt, 1989). Most agency theorists now recom-mend that corporations supplement board of direc-tor monitoring by using equity-based incentives,such as stock options, to align management inter-ests with those of shareholders (Gomez-Mejia,1994; Jensen & Murphy, 1990).

Despite the popularity of stock options as osten-sibly “free” compensation (Knight, 1998), theyhave five well-known shortcomings. First, uncon-trollable stock market changes often have more in-fluence on a firm’s stock price than do the operat-ing decisions that the firm’s CEO can control.Second, investor expectations similarly have alarge effect on stock prices. Third, managementdecisions that increase short-term stock price oftendo not benefit shareholders in the long term.Fourth, management stock options do not sharedownside risk with the actual shares held by share-holders. And fifth, management’s influence overstock price is limited to affecting operating perfor-mance, which is only one factor among others(such as investor expectations and discount rate) ina firm’s overall stock price (Knight, 1998, 2002).

Despite these shortcomings, stock options are apopular mechanism for aligning managers’ andshareholders’ interests. In a 2001 survey of 350major U.S. companies, Mercer Human ResourceConsulting found that gains from exercising stockoptions provided 70 percent of median CEO totaldirect compensation, comprised of salary, bonus,restricted stock, stock option exercise gains, andlong-term incentive payouts (Lublin, 2002) and setthe ceiling for the rest of these firms’ compensationstructures (Gomez-Mejia, 1994). According to thetraditional tenets of agency theory, increases inCEO stock options, along with effective monitoring,produce better alignment between the interests ofmanagement and shareholders. That is, both CEOsand shareholders benefit from rising long-run stockprices, thereby reducing the likelihood of moralhazard. Moreover, positively valued stock optionscreate risk for CEOs (Wiseman & Gomez-Mejia,1998). Risk is created because CEOs with positively

1 CEO duality occurs when a single individual servesas both the CEO of a company and the chair of its boardof directors.

2006 485O’Connor, Priem, Coombs, and Gilley

valued stock options have a good deal to lose per-sonally in the event of negative financial news, andan unexpected downward restatement of financialresults is among the worst possible financial newsa firm and its CEO can receive, especially from astock options value perspective. Therefore, CEOswith stock options will strive to ensure the legiti-macy of their accounting practices. Thus:

Hypothesis 1a. The higher the value of a CEO’sstock options, the lower the likelihood offraudulent financial reporting.

CEOs are sometimes faced with moral dilemmas,wherein pursuit of their own self-interest willcause harm to others over which the relevant othershave no control (Hosmer, 1994). We label as “un-principled agents” those managers who willfullytake actions that benefit themselves while nega-tively affecting potential shareholder value maxi-mization. Unprincipled agents facing moral dilem-mas engage in opportunistic behavior (Foss, 1996a,1996b; Gottfredson & Hirschi, 1990) if they haveboth the incentive and opportunity to do so(Coleman, 1995). The key question for corporategovernance is not whether a specific agent is prin-cipled or unprincipled; many principled CEOslikely would behave in the shareholders’ interestseven when offered considerable incentive and op-portunity to do otherwise. Instead, the question iswhether or not in the presence of an unprincipledagent a particular control mechanism will either (1)eliminate the moral dilemma by aligning the inter-ests of all parties or (2) monitor the unprincipledagent closely enough to ensure that there will be noopportunity for self-interested behavior to occur.Ideally, according to principal-agent theory, CEOstock options eliminate moral dilemmas by align-ing CEO interests with those of shareholders (al-though they may not perfectly do so) and, therefore,continued board of director monitoring is neces-sary. Next, we argue that, contrary to agency theory,stock options can actually exacerbate the moralhazard facing CEOs by providing extra incentive forself-interested behaviors. That is, when opportu-nity is present, options will increase the likelihoodof self-interested behaviors by unprincipled CEOs,ultimately harming shareholders.

Incentive. The accounting literature providesempirical evidence that CEOs have financial incen-tives to continually maintain or increase firm per-formance and to avoid lower-than-expected perfor-mance. For example, Payne and Robb (2000),Brown (2001), and Matsumoto (2002) demonstratedthat managers act to avoid negative earnings sur-prises. Matsunaga and Park (2001) showed that fall-ing short of quarterly earnings forecasts or of earn-

ings for the same period in a prior year adverselyaffected CEO cash bonuses. Further, Boschen,Duru, Gordon, and Smith (2003) demonstrated thatunexpectedly good stock performance positivelyaffected CEOs’ long-run cumulative financial gains.Thus, recent empirical studies have shown thatCEOs have much to lose financially if their firmsunderperform relative to expectations and havemuch to gain financially if their firms overperform.

Opportunity. No matter how strong the incen-tive, however, unethical or illegal actions cannottake place without opportunity. If firms compete indynamic, deregulated markets where successfulfirms make the “rules of the game,” and if thesefirms pursue diversified growth strategies withcomplex structures and decentralized controls, op-portunities increase for unprincipled agents to en-gage in opportunistic behaviors (Baucus & Near,1991; Daboub et al., 1995; McKendall & Wagner,1997; McKendall, Sanchez, & Sicilian, 1999). Ac-tions contrary to shareholders’ interests are partic-ularly difficult to detect when they involve “judg-ment calls” by the managers, such as CEOs, who areexpected to be the most knowledgeable about firmsand their activities (Jensen & Meckling, 1976). De-cisions concerning “aggressive” accounting prac-tices—in particular, financial misstatements de-signed to manipulate stock prices, misappropriatefunds, or facilitate insider trading—are judgmentsin which wrongdoing is particularly hard to iden-tify. In such situations, the opportunity for self-interested action is present, and increases in CEOstock options simply raise the incentives for suchaction and lead to a higher incidence of fraudulentfinancial reporting.

This line of reasoning is consistent with researchin accounting investigating the general hypothesisthat compensation plans can motivate CEOs tomake self-serving or even fraudulent decisions. Forexample, Barton (2001) found evidence in a sampleof Fortune 500 firms that cash compensation waspositively related to the use of earnings manage-ment techniques, while the value of stock ownedby a CEO and the number of options held by theCEO were related to the use of interest rate andforeign currency derivatives. Barton (2001) con-cluded that managers were purposely managingearnings to increase their cash compensation andusing derivatives to increase the value of theirstock-based compensation. In a study of firms pre-paring for initial public offerings (IPOs) of stock,DuCharme, Malatesta, and Sefcik (2001) reportedthat managers manipulated earnings to increaseproceeds from the IPOs at the expense of investors.Guidry, Leone, and Rock (1999) and Healy (1985)provided evidence that earnings management was


associated with CEOs’ bonuses, and Healy (1985)further found that bonus plan adoptions andchanges to bonus plans were associated withchanges in earnings management. Hirst (1994)demonstrated that bonus plans created incentivesfor executives to manage earnings in such a waythat their bonuses would be maximized. Further-more, although Gerety and Lehn (1997) found noclear relationship between the use of accounting-based management compensation plans, such asprofit sharing, bonuses, and stock options, and in-stances of accounting fraud, they did determinethat large stockholdings by a single executive re-duced the likelihood of fraud. Thus, the accountingliterature provides evidence that executives maymake company decisions designed to maximizetheir individual wealth. In other words, executivesmay “game” the incentive system, enabled by thepresence of “information asymmetry” (Baker,1992), behaving in ways that increase their ownrewards while reducing their firms’ performance.Hence,

Hypothesis 1b. The higher the value of a CEO’sstock options, the higher the likelihood offraudulent financial reporting.

The Moderating Effects of CEO Duality andBoard Stock Options

The strength of the proposed competing relation-ships between the value of CEO stock options andthe incidence of fraudulent financial reporting islikely influenced by two additional factors: CEOduality and board stock compensation. CEO dualityhas been consistently recognized as a conflict ofinterest in corporate governance, in part because itis also recognized as an indicator of CEO power(Coles & Hesterly, 2000; Daily & Dalton, 1994;Finkelstein & Hambrick, 1996). Although boardmembers are charged with governing firms and en-suring high levels of firm performance, they mayfail to do so effectively in the presence of CEOduality. CEOs who serve as board chairs gain influ-ence over board member nominations, compensa-tion setting, board agendas, and so forth, even ifthey do not formally serve on the committeescharged with those responsibilities. This influencemay compromise corporate governance. Prior re-search has shown that duality is related to higherexecutive compensation (Magnan, St-Onge, &Calloc’h, 1999), poison pill adoption (Mallette &Fowler, 1992), diversification (Zantout & O’Reilly-Allen, 1996), and takeover premiums (Hayward &Hambrick, 1997). These outcomes may result frompowerful CEOs who are also board chairs circum-

venting the governance process in an attempt toshape their organizations to their liking. Thus,CEOs who also chair their firms’ boards will holdgreater power that, in turn, will make it easier forthem to either (1) ensure the shareholders’ interestsare foremost, under the agency theory argument, or(2) pursue their own interests unchecked, underthe unprincipled agent argument. Therefore, CEOduality is proposed to enhance the relationship,whether positive or negative, between CEO stockoptions and accounting irregularities for either ofour competing hypotheses (Howell, Dorfman, &Kerr, 1986). Hence,

Hypothesis 2. The presence of CEO dualitystrengthens the association between the valueof CEO stock options and the incidence offraudulent financial reporting.

If board members receive stock options as part oftheir compensation, under the principal-agentviewpoint their interests become more aligned withthose of shareholders. This alignment helps to en-sure appropriate monitoring by boards, results infewer accounting irregularities (Finkelstein & Ham-brick, 1996), and suggests a lower likelihood offinancial statement fraud (Beasley, 1996). Underthe unprincipled agent viewpoint, however, theboard monitoring function, particularly as regardsuse of aggressive accounting to prop up a firm’sstock price, may be compromised. That is, direc-tors’ interests are aligned with CEOs’ interests inmaintaining a high stock price (McKendall et al.,1999). Therefore, directors’ monitoring would beless aggressive and the likelihood of subsequentfraudulent financial reporting would increase.Thus, board stock options are proposed to enhancethe relationship, whether positive or negative, be-tween CEO stock options and fraudulent financialreporting, again for either of our competing hypoth-eses. Hence, we propose:

Hypothesis 3. The presence of board of directorstock options strengthens the association be-tween the value of CEO stock options and theincidence of fraudulent financial reporting.

Beyond their individual moderating effects, how-ever, CEO duality and board stock options togetherlikely have additional, complementary effects onthe relationship between CEO stock options andfraudulent financial reporting. CEO duality is anindicator of CEO power, and board stock optionsare a sign of board influence. Together, CEO powerand board influence have mutually reinforcing ef-fects. That is, when present simultaneously, theycomplement one another to increase the overalleffect on the relationship between CEO stock op-


tions and fraudulent financial reporting beyond theindividual moderating effects. When incentives forself-interested behavior are present, for example,the influence of a powerful, unprincipled CEO ismagnified by an acquiescent board with stock op-tions and, reciprocally, an unprincipled board withstock options can exercise influence more effec-tively on a powerful but unprincipled CEO. Con-versely, the influence of a powerful but principledCEO is reinforced by a principled board with stockoptions, even in the presence of incentives, and aprincipled board with stock options can exerciseinfluence effectively when the CEO is powerful butprincipled. Following these arguments and thosepresented for Hypotheses 2 and 3 above, the simul-taneous presence of CEO duality, indicating power,and board stock options, indicating influence,would either (1) allow powerful, unprincipledCEOs to pursue their own interests with little in-terference from coopted boards of directors (e.g.,McKendall et al., 1999) or (2) allow powerful, prin-cipled CEOs to pursue shareholders’ interests sup-ported by rigorous board monitoring (e.g., Beasley,1996). Thus, jointly occurring CEO duality andboard stock options are reciprocally reinforcing,and joint occurrence further enhances the relation-ship, whether positive or negative, between CEOstock options and fraudulent financial reporting,again for either of our competing hypotheses.Hence, we propose:

Hypothesis 4. The simultaneous presence ofCEO duality and board stock options strength-ens the association between the value of CEOstock options and the incidence of fraudulentfinancial reporting, magnifying the individualmoderating effects.

Figure 1 summarizes these proposed relation-ships. The next section presents our empiricalstudy of these relationships.

METHODS

Sample Selection

The outcome of interest in our study was inten-tional financial misreporting that artificially in-flated a firm’s results. Because such fraudulent out-comes were relatively rare events, randomsampling was not feasible, and we instead used amore powerful matched-pair design. We first iden-tified firms that unambiguously had fraudulentlyinflated financial results and then, for each suchfirm, we identified a matching firm that had notdone so, as described below.

Firms restating financial results under pres-sure. We reviewed 12,222 articles using the Pro-Quest� Newspapers database of over 550 newspa-pers, searching full-text articles that appeared fromJanuary 1, 2000, to June 30, 2004, for variations ofthe word “restate.” The lead author and anothersubject expert were trained to identify firms (1) thathad restated their financial accounts downward, (2)whose misreporting was unrelated to changes inaccounting principles or to nonfinancial matters,and (3) that restated only after pressure by federalor state regulatory agencies responding to per-ceived malfeasance (e.g., an SEC-initiated investi-gation or a state public service commission order).2

Only firms that unambiguously met all criteriawere included. We focused on restatements made“under pressure” from regulatory agencies in orderto exclude the common situation in which federaland state regulatory inquiries are initiated after re-statements occur. In the latter situation, restate-ments may be the result of effective internal corpo-rate governance practices, and we wanted to limitour sample to those clearly intentional transgres-sors that restated only because regulatory agenciescompelled them to do so. An average of 278 firms

2 The SEC is the U.S. Securities and ExchangeCommission.

FIGURE 1Competing Corporate Governance Hypotheses


restated annually because of misreporting that ex-cluded changes in accounting principles or nonfi-nancial matters, but only about 20 annually clearlyrestated under pressure. Our review of ProQuest�articles identified 103 firms that met the restate-ment-under-pressure criterion during the period ofour study, out of an annual average of over 9,600U.S. independent public firms. Please note that“restatement year,” as used here, is the year when arestatement was made, not the fiscal year for whichresults were restated. Firms meeting our require-ments for fraudulent financial reporting includedsuch well-known transgressors as CMS Energy,Dynegy Incorporated, Qwest Communications In-ternational, and Rite-Aid Corporation.

Matching firms. We introduced a number of con-trols through our matching procedures, employingeight matching variables: firm independence, pub-lic ownership, U.S. citizenship, 1996–2004 timeperiod, industry (four-digit Standard IndustrialClassification code), 1996–99 average annual netsales, 1996–99 average net income, and 1996–99average annual vesting period. We identified closematches for 65 of the original 103 restated-under-pressure firms, and we used multiple approaches totest the effectiveness of our matching procedures.The Appendix contains details of the matching pro-cedures and effectiveness tests.

Two key factors that could affect the likelihoodof fraudulent financial reporting—industry andfirm characteristics—were controlled through ourmatching procedures. Industry factors that influ-ence white-collar crime include market structure,resource scarcity, environmental uncertainty, andregulatory environment. For example, highly con-centrated industry structures, resource scarcity,rapidly changing environments, and recent dereg-ulation have all been found to be antecedents ofcorporate illegality (Coleman, 1995; Daboub et al.,1995; McKendall & Wagner, 1997; McKendall et al.,1999). These potential sources of variation are con-trolled through matching by industry, defined byfour-digit SIC code.

Firm size is an important organizational varia-tion that can also influence the likelihood of white-collar crime. As companies grow, for example, theybecome more complex and often decentralize theiroperations, giving unprincipled agents more oppor-tunity to commit illegal acts while localizingawareness of such activities (Baucus & Near, 1991;Daboub et al., 1995; McKendall & Wagner, 1997;McKendall et al., 1999). We controlled for firm sizethrough matching firms by average annual netsales.

Time periods. In 1996, the Financial AccountingStandards Board required companies to begin ac-

counting for stock-based compensation using theBlack-Scholes option-pricing model (Balsam,Mozes, & Newman, 2003). Because we judged theBlack-Scholes method to be the appropriate one touse to value option grants (see “Independent vari-ables” below), we chose 1996 as the beginning ofthe four-year “treatment period” during which wemeasured our independent and control variables.The four-and-a-half-year “outcome period” for ourdependent variable was 2000–04 (only the first sixmonths of 2004 were included). We used multiyearrather than single-year treatment and outcome pe-riods for several reasons. First, since CEO andboard stock options are not granted every year ineach firm, using only one year would have riskedmissing large option grants in the years before orafter the single year chosen. Second, stock optionsdo not immediately “vest,” or become exercisable.Most firms in our study used two- to five-year vest-ing periods; for example, firms that offer stock op-tions with five-year vesting periods have 20 percentof the options available for exercise after each yearin a five-year period. Thus, it is necessary to aggre-gate option grants over a multiyear period to moreaccurately reflect CEO and board incentives. Fi-nally, we hypothesized causal relationshipswherein stock options granted affected fraudulentfinancial reporting and, subsequently, restatementsunder pressure. Thus, a time-lagged model wasnecessary, with CEO stock option grants as treat-ments preceding restatement-under-pressure out-comes in time.

Variables

Dependent variable. The dependent variablewas binary: whether or not a firm restated its finan-cial results downward under pressure from January1, 2000, through June 30, 2004. We used a binarydependent variable for two reasons. First, fraudu-lent financial reporting is an either/or phenome-non, occurring irrespective of the size of the fraud.Second, when financials have been reported fraud-ulently, the scope of the fraud is seldom unambig-uous, and “restatements of restatements” often oc-cur. Thus, one cannot accurately or soon determineeither the absolute or relative size of many frauds.

Independent variables. The three main effectvariables were average annual CEO stock options,board of director stock options, and CEO duality.Average annual CEO stock options—the averageannual value of stock option grants made duringthe period 1996–99—were measured in millions ofdollars. We obtained CEO stock option values fromStandard & Poor’s Execucomp� database for 88 ofthe 130 firms and from proxy statement data for the


remainder. The values were computed using theBlack-Scholes methodology applied to individualstock option grants (Black & Scholes, 1973). We aresensitive to criticism that the Black-Scholesmethod was designed to price exchange-traded op-tions and not employee stock options, for which nomarket exists (Gleckman, 2002). We neverthelessbelieved the Black-Scholes method was the mostappropriate for our study because it (1) had beenwidely used and validated in prior research (e.g.,DeFusco, Johnson, & Zorn, 1990; Finkelstein &Boyd, 1998; Kerr & Kren, 1992; Wright, Kroll, Lado,& Van Ness, 2002) and (2) would therefore give ourstudy, which examined an exceptional CEO behav-ior, comparability with previous studies that exam-ined CEO options and somewhat less extremebehaviors.3

The question of equity pay for directors bridgesthe issues of monitoring and incentive compensa-tion. Hambrick and Jackson’s (2000) study providesone indication of the potential effects of equity oroptions incentives for boards of directors. Theyfound that companies with directors who ownedcompany stock outperformed other firms. Like CEOstock options, board stock options may align boardmembers’ interests with shareholder interests.They also may create risk bearing similar to thatexperienced by CEOs, however, which may be agovernance benefit not associated with stock own-ership. In the present study, the presence of boardstock options was a binary variable coded 1 forpresence and 0 for absence.

CEO duality was also a binary variable indicatingthe presence or absence of this additional power.CEO duality was coded 1 if a firm’s CEO also served

as the chair of its board of directors at any timeduring the 1996–99 period; otherwise, it equaled 0.

Statistical control variables. Six control vari-ables were employed in our model: a firm’s averageannual number of audit committee meetings, aver-age CEO age, the average annual percentage of CEOstock ownership, the average annual CEO cashcompensation (composed of salary, annual bonus,long-term incentive plan payouts, and perquisitessuch as transportation, housing, tax payments,etc.), the average annual CEO restricted-stockaward, and the average annual CEO stock owner-ship market valuation.

Average annual audit committee meetings, aproxy for board vigilance, was a firm-level controlvariable. Although a higher percentage of outsidedirectors is typically associated with more inten-sive monitoring by a board (Daily & Dalton, 1994),we chose to use a finer-grained operationalizationof board vigilance that was particularly appropriatefor assessing financial malfeasance. Schnatterly(2003), for example, found that the number of auditcommittee meetings was negatively associated withthe number of white-collar crimes. An audit com-mittee is the “ultimate monitor” of a firm’s finan-cial reporting system (Klein, 2002: 437). Externalauditors are required to report both their findingsand their overall assessment of a company’sstrengths and weaknesses directly to its audit com-mittee (Cox, Grace, Haupert, Howell, & Wilcomes,2002), and this committee must meet separatelywith the company’s senior financial managementand with internal auditors to ensure that manage-ment actively manages recognized risks and avoidsmisstatements in financial reporting (Braiotta,2002). Moreover, since December 1999, the NewYork Stock Exchange and NASDAQ have requiredthat audit committees be composed of at least threeindependent, outside directors (Klein, 2002).

Average CEO age was included as a statisticalcontrol because of its relationships to managerialrisk propensity and moral judgment (e.g., Child,1974; Zahra, Priem, & Rasheed, 2005). Average an-nual CEO stock ownership percentage was used asan indicator of ownership effects, including align-ment with shareholder interests (Jensen & Meck-ling, 1976; McGuire & Matta, 2003; Miller, Wise-man, & Gomez-Mejia, 2002; Sanders, 2001).Average annual CEO stock ownership percentagewas measured by the number of shares eitherowned or exercisable within 60 days of a firm’sproxy statement filing (an SEC reporting conven-tion) divided by the total number of shares out-standing. Average annual CEO stock ownershipmarket valuation was used to incorporate potentialwealth effects and downside risk, which, according

3 To convert firm Black-Scholes data, which containeddiffering assumptions involving interest rates, stockprice volatility, and grant-to-exercise duration, to thecommon assumptions of Execucomp� Black-Scholesdata, several steps were required. First, to address indus-try-varying stock price volatility, we grouped 88 compa-nies for which we had both firm and Execucomp� Black-Scholes data into five broad industry categories using SICcodes 1–3, 4, 5, 6, and 7–8. Second, to address interestrate volatility, we constructed four linear regressionmodels corresponding to the years 1996–99 for each cat-egory, obtaining a total of 20 linear regression models.For each model, we obtained a significant F-ratio (p �.05, with 19 significant at .01) and an adjusted R2 exceed-ing .90 in 17 of the 20 models. For each of the 42 firmswithout Execucomp� CEO stock option values, we thenconverted the Black-Scholes data from their proxy state-ments to Execucomp� Black-Scholes equivalents usingthe appropriate linear regression equation.


to prospect theory (Kahneman & Tversky, 1979),make CEOs more risk-averse (Sanders, 2001). Sand-ers (2001) noted, for example, that although CEOstock options associated with upside potential pro-mote risk-taking behavior, CEO stock ownershipinstead promotes risk-averse behavior. Thus, ahigher average annual CEO stock ownership marketvaluation may be associated with a lower incidenceof fraudulent financial reporting. Moreover, in-creased CEO stock ownership wealth is also asso-ciated with higher firm performance (Kay, 2004;McGuire & Matta, 2003). We computed average an-nual CEO stock ownership market valuation as thenumber of CEO-owned, exercisable shares reportedin a firm’s proxy statement multiplied by the aver-age of the high and low stock prices for each of ayear’s four quarters, as reported in the firm’s SECForm 10-K Annual Report.

Average annual CEO cash compensation and av-erage annual CEO restricted stock were included ascontrols because they represent trade-offs in anoverall CEO compensation package—for example,more options for less salary—and thus modify therelative importance of stock option grants to aCEO’s overall compensation (Sanders, 2001).

DATA ANALYSIS AND RESULTS

We tested our hypotheses using the conditional(i.e., case-control-matching) logistic regressionmodel (Agresti, 2002; Hosmer & Lemeshow, 2000)and general estimating equations, for several rea-sons. First, in our matched-pairs design each paircontained one firm in which downward restate-ment under regulatory pressure occurred and one

in which it did not. Thus, the dependent variablewas binary. Second, the matched-pairs method em-ploys a conditional distribution, with the distribu-tion of Yi fixed (each matched pair has one 1 andone 0) and therefore subject-specific, instead ofmarginally distributed and population-averaged.And third, general estimating equations are partic-ularly useful for categorical repeated measure-ments such as these (Stokes, Davis, & Koch, 2000)and produce robust estimations (Allison, 1991).There is no overall intercept term in conditionallogistic regression because such a term would in-terfere with the case-based estimates of the otherparameters (Agresti, 2002).

Table 1 presents the means, standard deviations,and zero-order correlations for all variables in-cluded in our study. Uncentered means are shown,but we centered all continuous (nonbinary) vari-ables, as Aiken and West (1991) suggested, beforehypothesis testing. Table 2 shows our logistic re-gression models.

Model 4 is the full, unrestricted model in whichwe entered the six statistical control variables,three main effects for the variables in our hypoth-eses, and all interaction terms to ensure a rigoroustest of the hypothesized effects. The significance ofthe triple interaction term in model 4 indicated thatthis term contributed to model significance thatwas greater than that of the restricted model 3. Thelikelihood ratios comparing the further restrictedmodels, from which the double interactions (model2) and main effects (model 1) were also removed,indicated that the double interaction terms togetherand main effect terms together each contributed tooverall model significance and that the full, unre-

TABLE 1Descriptive Statistics and Correlationsa

Variable Mean s.d. 1 2 3 4 5 6 7 8 9

1. Case 0.50 0.502. Average annual audit committee meetings 3.10 1.98 �.17*3. Average CEO age 54.12 7.28 �.22* .26**4. Average CEO stock ownership 7.07 13.31 .01 �.25** �.15†

5. Average annual CEO cash compensation 1.82 3.00 �.01 .47*** .19* �.146. Average annual CEO restricted stock 1.65 14.80 .10 .02 �.00 �.02 .147. Average annual CEO stock ownership

market valuation220.52 1,265.53 �.04 .03 �.03 .22* .04 .09

8. Average annual CEO stock options 4.50 11.51 .06 .01 �.06 �.04 .26** .05 .40***9. Board of director stock options 0.72 0.45 .00 �.08 �.18 �.04 �.10 .06 .07 .13

10. CEO duality 0.75 0.44 .09 .08 .19* .22* .11 .06 .08 �.07 .07

a The table displays the means of uncentered variables. (The binary variables were not centered.) The standard deviations, correlations,and probabilities of the centered and uncentered variables are identical. n � 130.

† p � .10* p � .05

** p � .01*** p � .001


stricted model 4 had the greatest explanatorypower (Bowen & Wiersema, 2004). Thus, we usedmodel 4 for hypothesis testing.

Hypothesis 1a asserts that the greater the value ofa CEO’s stock options, the less likely the subse-quent incidence of fraudulent financial reporting,and Hypothesis 1b counters that fraudulent finan-cial reporting is more likely with higher values ofCEO stock options. The CEO stock options oddsratio of 0.63 in model 4 suggests that a $1 millionincrease in options decreases the likelihood offraudulent financial reporting by 37.2 percent. Thisresult supports principal-agent theory, embodiedin Hypothesis 1a, and not the unprincipled agentview represented by Hypothesis 1b. But this overallresult must be interpreted in the context of theeffects of the higher-order interactions, discussednext.

Hypothesis 2 states that the presence of CEOduality increases the effect of CEO stock options onthe likelihood of fraudulent financial reporting,and Hypothesis 3 argues that the presence of board

stock options increases the effect of CEO stock op-tions on the likelihood of fraudulent financial re-porting. The significant double interactions inmodel 4, however, show that the overall salutaryeffect of increasing CEO stock options is reduced inthe presence of either CEO duality or board stockoptions. The significant triple interaction term inmodel 4 supports Hypothesis 4, indicating the pres-ence of an even more complex relationship,wherein CEO stock options, CEO duality, andboard stock options jointly affect the likelihood offraudulent financial reporting. We diagram thesejoint effects in Figure 2 (Jaccard, 2001).

Figure 2 shows the relationships between CEOstock options, CEO duality, board stock options,and fraudulent financial reporting. When CEO du-ality and board stock options both exist, the rela-tionship between CEO stock options and the like-lihood of fraudulent financial reporting is negative.When CEO duality and board options are both ab-sent, increases in the value of CEO options alsodecrease the likelihood of fraudulent financial re-

TABLE 2Results of Conditional Logistic Regression Analysis for Fraudulent Financial Reportinga

Variable Model 1 Model 2 Model 3

Model 4

CoefficientsOddsRatio

Control variablesAverage annual audit committee meetings �0.20† �0.22† �0.23† �0.28* 0.76Average CEO age �0.06* �0.07* �0.09** �0.10** 0.91Average CEO stock ownership �0.01 �0.01 �0.02 �0.12 0.98Average annual CEO compensation

Cash compensation 0.06 0.02 0.05 0.04 1.04Restricted stock 0.12 0.33 0.26 0.46 1.59Stock ownership market valuation �0.00 �0.00 0.00 0.00 1.00

Main effects variablesAverage annual CEO stock options 0.02 �0.11 �0.47* 0.63BOD stock options �0.35 �1.00 �0.63 0.54CEO duality 0.88* �0.15 0.89 2.44

Interaction variablesAverage annual CEO stock options � board of director stock options 0.22† 0.76** 2.15Average annual CEO stock options � CEO duality �0.13 0.51† 1.66Board of director stock options � CEO duality 1.72* 0.57 1.76Average annual CEO stock options � board of director stock options

� CEO duality�0.84** 0.43

Scale parameter 1.02 1.03 1.02 1.01Model fit: Pearson chi-square (p)b 127.90 (.39) 127.44 (.33) 123.43 (.35) 118.44 (.45)Log-likelihood �81.33 �77.02 �73.77 �71.95Between-model likelihood ratio (chi-square) 8.60* 6.52* 3.63†

124 121 118 117

a n � 130 (65 pairs of companies).b The null hypothesis is rejected if p � .05. The more the p-value exceeds .05, the better the model fit (Agresti, 2002).

† p � .10* p � .05

** p � .01


porting. Thus, when CEO duality and board stockoptions are either simultaneously present or simul-taneously absent, increases in CEO stock optionsdecrease the likelihood of fraudulent financial re-porting. When CEO duality exists but board optionsdo not, however, the relationship between thevalue of CEO stock options and the likelihood offraudulent financial reporting is positive. Simi-larly, when duality is absent but board options arepresent, the relationship between CEO stock op-tions and the likelihood of fraudulent financial re-porting is also positive, with the greatest effect athigher levels of CEO options. Thus, when eitherCEO duality or board stock options is present whilethe other is absent, increases in CEO stock optionsincrease the likelihood of fraudulent financialreporting.

Together, these findings support the moderatingeffects of CEO duality (Hypothesis 2) and boardstock options (Hypothesis 3) and the joint effects ofthese variables (Hypothesis 4) on the relationshipbetween the value of CEO stock options and thelikelihood of fraudulent financial reporting. Theeffects we found, however, are more complex thanthose we initially hypothesized, and findings didnot entirely support our hypotheses, as we discussbelow.

DISCUSSION

Our findings both support and extend those ofprevious research. Two of our statistical controlvariables are significantly related to the likelihoodof fraudulent financial reporting, as we expectedfrom previous research findings. These results con-firm the important roles of boards of directors and

individual CEOs in corporate governance. First, theaverage annual number of meetings of a firm’s auditcommittee is negatively related to the likelihood offraudulent financial reporting, supporting the com-mittee’s monitoring and deterrent functions exam-ined by Klein (2002) and Schnatterly (2003), re-spectively. Second, CEO age is negatively related tothe likelihood of fraudulent financial reporting, aswe expected from previous research findings relat-ing age to both risk aversion and less propensitytoward criminality (Child, 1974; Gottfredson & Hir-schi, 1990). Furthermore, Figure 2 shows that CEOduality also produces a greater likelihood of fraud-ulent financial reporting when CEO stock optionsare not present. This finding is consistent witharguments in the literature regarding the power andautonomy associated with CEO duality (Coles &Hesterly, 2000; Daily & Dalton, 1994; Finkelstein &Hambrick, 1996), and it supports prior research.

We also extended previous research, by offeringcompeting arguments concerning the likely effectsof CEO stock option grants on fraudulent financialreporting. One argument was based on a commonprescription of principal-agent theory (Jensen &Meckling, 1976): that granting CEOs’ stock optionsincreases their financial interest in long-term shareperformance, thereby aligning the CEOs’ interestswith those of shareholders and ensuring actionsthat will benefit shareholders. The counterargu-ment, which we labeled the unprincipled agentview, is that once stock option grants become exer-cisable they provide an immediate financial incen-tive for CEOs to inflate near-term financial perfor-mance at the expense of long-term results. Thus,according to this viewpoint, CEO stock optiongrants might actually hurt shareholders, because

FIGURE 2Interactions of CEO Stock Options by Board Stock Options by CEO Duality


they could result in fraudulent financial reportingand a reduction in long-term share performance.

Our results are mixed concerning the principal-agent theory assertion that increased CEO stockoptions can align CEO interests with those of share-holders; evidence of this alignment occurred onlyin very circumscribed situations in our sample. Wefound that increasing CEO stock options led to adecreased incidence of fraudulent financial report-ing, as predicted by agency theory, only when (1) afirm’s CEO was also board chair and the firm’sboard had stock options, or when (2) the CEO wasnot board chair and the board had no options.Counter to principal-agent theory, we found thatincreasing CEO stock options were associated witha greater incidence of fraudulent financial report-ing when (3) a CEO was also board chair and theboard was without stock options, and much morefraudulent financial reporting occurred when (4)the CEO was not board chair and the board hadstock options. These findings are not preciselyaligned with the predictions in our hypotheses,however. We expected that two combinations—CEO duality with board options, and no dualityand no board options—would have the largest ef-fects, but that was not the case. Instead, with highlevels of CEO options we found, as expected, thatno CEO duality with no board options producedthe least likelihood of fraudulent financial report-ing in our sample, but we also unexpectedly foundthat no CEO duality with board options resulted inthe greatest likelihood. We next offer some inter-pretations of these findings.

Generally, our results indicate that the effects ofboard stock options and CEO duality differ as thevalue of options held by a CEO increases. With noCEO stock options, CEO duality is the dominanteffect and is associated with a greater likelihood offraudulent financial reporting. This finding is con-sistent with the arguments that CEO duality indi-cates CEO power (e.g., Dailey & Dalton, 1994) andthat some CEOs may use such power to circumventcorporate governance processes. As a CEO receivesmore and more stock options, however, whether ornot his or her board of directors also has stockoptions has an increasing influence on the likeli-hood of fraudulent financial reporting. Further-more, this influence varies depending on whetheror not the CEO is also chairperson of the board.When the CEO is not chair and the board has nooptions (situation 2 above), the likelihood of fraud-ulent financial reporting decreases to its lowestlevel for our sample as CEO options increase. Inthis situation, the external chairperson and boardmembers maintain their monitoring function andappear particularly vigilant as the CEO’s options

increase, even without extra, agency-based “inter-est alignment” from stock options of their own.When the CEO is not also the chair and board stockoptions are present, however (situation 4 above),the likelihood of fraudulent financial reporting in-creases greatly as CEO options increase. This pat-tern of findings contradicts the agency theory argu-ment that stock options for directors increase theirvigilance and engagement (Finkelstein & Hambrick,1996; Hambrick & Jackson, 2000) as well as the ideathat the relatively low power of a nonchair CEOalways limits opportunistic behavior on his or herpart. It may be that in such cases board stock op-tions coopt the board (including its chairperson) byproviding incentives for members to abrogate theirinternal monitoring role and “turn a blind eye” toactions designed to keep short-term stock pricehigh. This effect may be reinforced by the likeli-hood that the value of board options increases withthe value of CEO options (Gomez-Mejia, 1994). An-other potential explanation of our results for thecombination of nondual CEO with board stock op-tions is that the directors may assume that theoutside chair—who is often a former CEO—is doingeffective monitoring, and so they therefore decreasetheir collective vigilance. This decreased vigilancewould allow the CEO greater freedom to pursueactions that promote personal gain as the value ofCEO stock options increases.

When a firm’s CEO was also board chair in oursample, on the other hand, increasing CEO optionswere associated with a lesser likelihood of fraudu-lent financial reporting when the firm’s board ofdirectors also had options (situation 1 above). Thisapparent vigilance over a powerful CEO may occurbecause board stock options result in increased vig-ilance, as agency theorists hold (Finkelstein &Hambrick, 1996; Hambrick & Jackson, 2000), or itmay occur because CEO duality itself spurs boardvigilance (Finkelstein & D’Aveni, 1994). IncreasingCEO options when a CEO was also chairperson,however, was linked with greater likelihood offraudulent financial reporting if a board had nooptions (situation 3 above). In this latter case, itmay be that the dual CEO’s greater power to pursueself-interest simply overwhelms the board’s inten-tions to monitor. Such dominance by powerfulCEOs is consistent, for example, with Pollock, Fi-scher, and Wade’s (2002) similar finding that CEOduality was associated with repricing of CEOs’stock options.

Our study has a number of limitations that mustbe kept in mind when evaluating these results.First, the relative infrequency of financial reportingfraud kept our sample fairly small: only 103 (re-duced to 65) companies from our population of


approximately 9,600 U.S. public firms had beendiscovered (at the time of data collection) to haveengaged in fraudulent financial reporting under thestrict selection standards we set. This number oftransgressive firms resulted in a matched-pair sam-ple of 130 firms in total. The matched-pair design isrelatively powerful, however, and is increasinglyso as matching accuracy increases (see, for exam-ple, Sheskin [2000]; Appendix A provides ourmatching procedures). Second, our sample primar-ily consisted of large U.S. firms, but forced finan-cial restatement likely is a phenomenon that alsooccurs in smaller firms. During the period 1998–2003, for example, the Huron Consulting Group(2003, 2004) found that 48–49 percent of firmsrestating because of fraudulent financial reporting(excluding changes in accounting principles andnonfinancial matters) had annual net sales of lessthan $100 million. Only 7.7 percent of the 65 re-stating firms in our study had annual net sales ofless than $100 million. This discrepancy could be aconsequence of the greater publicity given largerfirms, which affected our likelihood of detectingsuch firms restating under regulatory pressure vianews accounts; or the discrepancy could be a con-sequence of the greater regulatory attention thatlarge firms face. Thus, our findings are more gen-eralizable to larger firms than to all U.S. companies.Third, several of the firms for which we could notfind appropriate matches were outliers in one wayor another. Often, they were very large firms thatdominated concentrated industries (e.g., Enron).Thus, one must be careful in generalizing our re-sults to dominant firms in concentrated industries.Fourth, our results may not extend to private enter-prises, where there may be higher levels of moni-toring than in public companies and where manag-ers bear higher compensation risk than do theircounterparts in public corporations (Tosi & Gomez-Mejia, 1989). Finally, we were unable to includethe degree to which the CEO options in our samplewere “in the money” in our analyses, because wecould not determine unambiguously when the de-cision was made to misreport financials. Our re-sults suggest that the Black-Scholes option valueover a range of years is a useful measure of incen-tive compensation. Future research incorporatingin-the-money value may produce additional in-sights, however, particularly regarding optionholders’ behaviors as the price of a stock ap-proaches (but hasn’t yet reached) the option “strikeprice.”

Notwithstanding these limitations, our resultshave a number of important implications for re-searchers and practitioners. For researchers, ourfindings suggest that the effects of governance

mechanisms on managerial behavior are more com-plex and more interactive than has been hypothe-sized. Some scholars have noted the limitations ofconsidering each governance mechanism indepen-dently of others and have advocated examination ofjoint or substitution effects (e.g., Agarwal &Knoeker, 1996; Rediker & Seth, 1995). Our findingsindicate that simple substitution may be too basic.Future research instead should focus on joint ef-fects that may reflect power relationships betweena CEO, a board of directors, and a non-CEO boardchair, and on the effectiveness of various incentivesfor these parties. Clearly, many issues concerningincentives remain to be investigated, including thefollowing: how stock options could be imple-mented more effectively; the relative effects ofstock ownership versus stock options; and the in-fluences of CEO, nonexecutive chairperson, andboard power, and the balance of such power, on thedesign and implementation of incentives. Studiescomparing the various forms of board compensa-tion and their influence on corporate governanceare needed. Simultaneous (i.e., interactive) effectsof governance mechanisms on fraudulent financialreporting, and curvilinear relationships, shouldalso be explored. For example, Latham and Jacobs(2000) found that management stock ownership of0–5 percent and over 25 percent was conducive toalignment with shareholder interests, but that op-portunism occurred in the 5–25 percent range(where our sample’s 7 percent mean is located).Thus, many corporate governance issues warrantfurther research.

Nevertheless, important advice can still be pro-vided for practitioners. A firm’s board plays a keyrole in the firm’s governance through both its auditand compensation committees. Effective monitor-ing by the audit committee is essential to goodcorporate governance. Our results show that mon-itoring via frequent audit committee meetings is aneffective deterrent to fraudulent financial reportingby managements in large firms. Development ofCEO incentives by a board’s compensation commit-tee can also be an effective deterrent, but only ei-ther when the CEO is also chairperson and theboard has stock options, or when the CEO is notchairperson and the board doesn’t have options.With other combinations of CEO duality and boardoptions, increasing CEO options increases the like-lihood of fraudulent financial reporting. Alterna-tive forms of executive compensation that increaseownership risk, such as restricted stock grants, mayyield better alignment with shareholder intereststhan do CEO stock options. Also, the unfavorableeffect that board stock options sometimes appear tohave on fraudulent financial reporting raises con-


cerns about the consistency of the fiduciary roledirectors serve for shareholders. This effect alsovalidates increases in the external monitoring ofregulators (via the Sarbanes-Oxley Act of 2002, forinstance) and heightened activism by outside insti-tutional observers (e.g., CalPERS).4 Finally, our re-sults indicate that CEO duality is neither univer-sally positive nor universally negative for corporategovernance. In a firm with CEO duality, the worstsituation as regards potential fraudulent financialreporting arises when the board of directors is with-out stock options and the value of CEO options ishigh. Without CEO duality, the worst situation asregards potential fraudulent financial reporting oc-curs when the directors have stock options and thevalue of CEO options is high. Further research isneeded, however, before more specific policy rec-ommendations can be made with full confidence.Evidently, effective deterrence may not be asstraightforward as previously thought.

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APPENDIX

Matching Procedures

The initial sample of 103 companies was reduced to 65owing to firms’ failure to meet selection criteria or inabil-ity to be matched. The 38 firms removed from the sampleincluded 25 that failed to meet the criterion of beingindependent, U.S. public firms during the full period1996–2004 because of corporate turbulence in the form ofacquisitions, liquidations, and the like. Also, 13 wereeliminated because we could not find firms that matchedthem on the basis of 1999 industry (four-digit SIC) codeand 1996–99 average annual net sales. Five of the match-ing covariates—independence, U.S. “citizenship,” publicownership, 1996–2004 time period, and industry—werecategorical. The primary data source for these five cate-gorical matching covariates was the SEC’s EDGAR data-base, primarily SEC Form 10-K Annual Reports and DEF14A Definitive Proxy Statements (U.S. Securities andExchange Commission, 2004). Brief descriptions of thematching criteria follow.

Matching Criteria

Independent public firm in 1996–2004. All 130 firmsin the 65 matched pairs were independent, public firmsduring the entire period 1996–2004, but only the first sixmonths of the last year, 2004, were included .

U.S. citizenship. All but 2 of the 130 firms were incor-porated under U.S. law. To address the possibility thatchanges in corporate citizenship by United States–head-quartered firms truncated our sample (for instance, TycoInternational became a Bermuda corporation while re-taining its headquarters in the United States), we alsoexamined 41 U.S. “expatriate firms.” Four were found tohave restated financials under pressure during the period2000–04. Two of those four failed to meet the criterion ofindependence and public trading throughout the focalperiod, leaving two expatriates in the sample of 65matched pairs.

Four-digit SIC. All firms except one were matched onthe basis of the four-digit SIC code found in the U.S. SECForms 10-K Annual Reports filed for the fiscal year mostclosely identifed with calendar year 1999 (U.S. Securities

and Exchange Commission, 2004). Both the 1999 and2004 SIC codes of the exceptional firm, a conglomerate,bore no relationship to any of its four business segments.Thus, we matched it to another conglomerate whose1999 and 2004 SIC codes also had no relation to its fivebusiness segments. Instead, the match was based on theidentical four-digit codes of the two largest segments ofboth firms, as well as on the closeness of their 1996–99average annual net sales.

1996–99 average annual net sales and 1996–99 aver-age net income. We calculated these values as simpleaverages.

1996–99 average annual vesting period. Average an-nual vesting period, measured in years, was determinedeach year for each firm by the vesting described for stockoption grants for its executives during that year. Wherevesting periods differed among a firm’s stock optiongrants, we used weighted averages using numbers ofshares to compute that year’s average vesting for thatfirm. We also computed the average of the four years’average vesting periods during 1996–99 for each firm.Mean/median average annual net sales, net income, andvesting period were, respectively, $3.98/0.97 billion,$274/50 million, and 3.2/3.5 years. Data for 1996–99average annual net sales and net income were obtainedfrom the COMPUSTAT North American database supple-mented by SEC Forms 10-K (U.S. Securities and Ex-change Commission, 2004). Average vesting periodswere computed from vesting data in SEC Forms 10-K andDEF 14A (U.S. Securities and Exchange Commission,2004).

Tests of Matching Effectiveness

Along with industry classification, 1996–99 averageannual net sales was a key matching covariate. We there-fore measured the fit in the sizes of two matched firms asthe absolute value of the difference in the 1996–99 aver-age annual net sales of the two firms divided by therestating firm’s 1996–99 average annual net sales. Defin-ing perfectly matched sizes for all firms as 1.00, weobtained an average match of 0.80. To test the effective-ness of the overall matching process, and to detect thepresence of any remaining selection bias, we used theeight matching covariates and the 65 matched pairs topredict restatement under pressure. A conditional logis-tic regression model was employed, the same model usedto test this study’s hypotheses. Model fit and parameterestimate statistical insignificance, in relation to the out-come variable, would demonstrate satisfactory matchingand minimal selection bias. On a multivariate basis, theoverall model of eight matching covariates was found tobe statistically insignificant (p � .10), thus demonstrat-ing matching effectiveness and minimal selection bias inthe 65 matched pairs constituting this study’s sample.Both full and reduced matching models showed little orno multicollinearity (variance inflation factors rangedfrom 1.00 to 1.48, where 10 is the threshold for multicol-linearity), and no rejection of the null hypothesis ofhomoscedasticity (p � .05).


Joseph P. O’Connor, Jr. ([email protected]) is an assis-tant professor of management at the University of Texasat El Paso College of Business Administration. He earnedhis Ph.D. in organizations and strategy at the Universityof Wisconsin–Milwaukee. His research interests includethe strategy-making process and the relationships be-tween organizational learning, innovation, and strategicdecision making.

Richard L. Priem ([email protected]) is the Robert L. andSally S. Manegold Professor of Management and Strate-gic Planning and a professor of management in the Shel-don B. Lubar School of Business at the University ofWisconsin–Milwaukee. He earned his Ph.D. in strategicmanagement at the University of Texas at Arlington. His

research interests include the strategy-making processand chief executive decision making.

Joseph E. Coombs ([email protected]) is an assis-tant professor of management at Texas A&M University.He received his Ph.D. from Temple University. His re-search interests include geographic clustering, organiza-tion legitimacy, executive compensation, and corporategovernance.

K. Matthew Gilley ([email protected]) is an associateprofessor of management at Oklahoma State University.He holds a Ph.D. in strategic management from the Uni-versity of Texas at Arlington. His research interests in-clude executive compensation, corporate governance,and outsourcing.


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