The Influence of Executive Compensation and Firm Performance on Financial Misrepresentation
Introduction
Financial misrepresentation is a damaging corporate misconduct that can hurt stakeholders and the firm. Executive compensation and firm performance can influence corporate misconduct such as financial misrepresentation in an attempt by the executive to meet set goals. Revelations of such misconduct often damage corporate stakeholders, results in ruinous economic outcomes, and damage to vital economic institutions. This paper will analyze how firm performance and executive compensation can influence financial misrepresentation.
Executive Compensation
Executive compensation is remuneration packages for senior management and executive-level employees. Executives-level employees and senior management play a vital role in the company as they are mandated to make viable strategies, make important decisions and ensure the profitability of the company. To get the executives to perform, many companies resort to compensations and incentives intending to motivate them. There are a number of benefits packages including short term incentives, salary, long term incentives, insurance, perquisites and guaranteed severance package. These executive compensations are negotiable and vary in different companies depending on the company’s board of directors. In many companies, top executives and the CEO are mostly paid a salary plus short-term incentives which have performance goals attached to it. The CEO could get bonuses based on revenue growth and incremental profitability while the sales’ director, for instance, may get a bonus based on incremental revenue growth turnover.
Many companies use stock options in executive compensation packages as a big percentage of corporate value is tied up in stock options. Hence CEOs of the largest U.S. companies get large awards in stock options more than their bonuses and salaries combined. This clearly shows the emphasis on CEO incentive compensation thus the connection between individual compensation and firm performance.
Executives financial incentives have evolved over the past decades from 1978 when it was 100 times the pay of a typical worker to new highs of hundreds of millions for CEO’s a 940% rise as of 2018. Short term incentives generally increased by five per cent from 2018 to 130% in 2019. However, large companies with above $10bn company revenue experienced 10% points on target bonus from 150% in 2018 to 160% in 2019.
Corporate misconduct such as financial misrepresentation can arise if participants with the ability to implement misconduct- executive management can benefit from the misconduct. There are set goals and performance targets for the CEO to meet in order to attain bonuses and incentives. Thus, the CEO can legitimately work to decrease costs, increase real sales and earnings to improve real performance. However, the CEO may also be tempted to increase reported organizational performance through misrepresentation of the company’s financial status.
The huge stake in executive compensation may tempt the CEO to engage in unethical activities to attain financial misrepresentation. The misrepresentation will improve reported firm performance thus having a direct positive impact on stock prices and thus executive compensation. Whereas equity incentives can be beneficial, they create perverse incentives for unethical executives. Opportunistic executives have the incentive to engage in fraudulent activities such as earnings management, accounting restatements and financial misrepresentation. thus they benefit from shoring up the current stock price and cash-out by exercising vested options which they sell as shares at inflated prices.
A recent unethical practice and reputation damaging executive compensation pressure to perform is the wells Fargo scandal. The senior management incentive plan that guaranteed bonuses when sales quotas were met lead to misrepresentation of financial status as employees opened almost two million fraudulent accounts so as to meet certain financial goals (Cavico, et al. 2017). The vice president – Carrie Tolstedt would receive upto $9 million in incentives while she received a salary of $1.7 million annually.
Financial misrepresentation and fraud need at least three simultaneous circumstances; the opportunity to defraud, the perpetrator’s willingness to deceive and the motive to defraud. Without the opportunity to commit fraud, the motivation and willingness of the perpetrator do not matter for they cannot commit the fraud. In companies, top executives especially the CEO have the needed opportunity to commit fraud, they might have a motive- to increase their incentives and compensations and they also might be willing. There is evidence over time of Chef Executive officers of reputable and well-known firms who have been convicted of financial misrepresentation and reporting fraud. CEO’s reputable U.S. Firms such as Adelphia Communications, WorldCom and Tyco International have been victims of financial reporting fraud. International firms, on the other hand, have also had a share of financial misrepresentation as CEO’s of Satyam computer services Ramalinga Raju and Italy’s Parmalat Calisto Tanzi has also admitted to financial misreporting.
Firm Performance
The measure of performance of a firm is not only based on company efficiency but also its operational market. There are various measures that can be used to evaluate the performance of a firm. These measures- return on equity, capital adequacy, revenue, stock prices, profit margins and sales growth among others are prone to financial misrepresentation. The relative value of the financial measures of a firm concerning its competitors in the same industry is another factor to consider when evaluating a firm’s performance.
Firms have performance goals and targets they have set and ought to meet in order to be competitive. Organizations strive to achieve their goals and aspirations and thus find ways to achieve their aspirations to remain competitive and attract capital investments. Firms that do not meet their aspirations and goals look for ways to enhance reported performance. The two prevalent factors that drive a firm’s aspiration are the performance of other firms and the firm’s historical performance.
The social comparison to the performance of similar firms is a major driver for a firm’s performance and aspirations as it will either rise or fall with respect to other firms. Thus the measure of relative performance is crucial in determining the aspirations of an organization. To obtain the relative performance, the firm’s performance is subtracted from its aspiration levels. This will highlight the probability of a firm to falsify financial reports. Positive relative performance is obtained by attaining performance above the reference point while negative relative performance is below the reference point. Firms that attain close to reference point performance may hope to achieve its aspirations legitimately however, firms performing far below the reference point are more prone to misrepresentation.
Prior firm performance is a vital driver of misconduct such as financial misrepresentation when the firm encounters setbacks. When firms start recording undesired performance, managers have strong incentives to portray an image of sustained positive performance. This is attributed to the fact that they want to exercise incentive stock options on favourable terms and raise funds externally. Secondly, in cases of subsequent fraudulent behaviours, superior prior organization performance is effective in deterring detection since it lowers monitoring intensity from regulators, investors, the board and auditors.
A company’s performance significantly above its past performance is another motivating factor of financial misrepresenting in a firm. Thus market analysts and managers may base their aspirations for a company based on past performance. A problem arises when the last year’s exceptional performance was partly luck. The difficult problem is the firm’s inability to meet the expected performance or replicate last year’s high performance. The inability to meet these performance goals will result in a negative view from the market and thus such firms may resort to misrepresentation in an attempt to equal or surpass past performance.
Investor belief on good industry business conditions and prospects attributed to weak investor monitoring incentives is a huge simulator of fraudulent firm performance and corporate financial fraud. This is fueled by short-term executive compensation benefits which make the manager engage in financial misrepresentation. Furthermore, the cost of equity capital increases substantially in cases of fraudulent events for the fraud firm, thus indicating a likelihood of financial misreporting when faced with a setback following a good performance period.
Firm performance is hugely impacted by the executive management and as such, their compensations and incentives are impacted by firm performance. Firm managers, therefore, strive to ensure that tha firm is profitable for them to get their bonuses and incentives. However, when they cannot attain profitability, there is a possibility of financial misrepresentation to at least ensure they get their bonuses. This financial misrepresentation will portray a positive firm performance status and as such attain their bonuses.
Conclusion
In conclusion, the relationship between executive compensation primarily in stock options influences the possibility of financial misrepresentation. stock-based compensation cuts both ways as it acts as a double aged sword, it has beneficial effort in one hand- inducing managers to put effort into improving the firm’s value. But also leads to costly information manipulation through performance exaggeration reducing the firm’s values and costing the firm resources. Poor organizational performance relative to aspirations and prior firm performance increases the likelihood of financial misrepresentation and poor relative performance. Furthermore, Financial misrepresentation has a huge negative effect on subsequent organizational operating performance.
References
https://rewards.aon.com/en-us/insights/articles/2019/2019-pay-trends-first-look-at-ceo-compensation
Cavico, F. J., & Mujtaba, B. G. (2017). Wells Fargo’s fake accounts scandal and its legal and ethical implications for management. SAM Advanced Management Journal, 82(2), 4