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High powered Incentives and Fraudulent Behavior: Stock based versus Stock Option based Compensation

  • R. Andergassen

In this paper shareholders face the trade-off between providing managers with incentives to exert beneficial effort and to engage in costly fraudulent activity. We solve for the optimal compensation package, given that shareholders can either grant (restricted) stock or stock options and given fixed average compensation costs. We show that if the negative effect of fraud on the company’s value is sufficiently large then stock based compensation is optimal. Otherwise, stock option based compensation is optimal. Furthermore, we show that the fraud to effort ratio is increasing in the strike price and that the optimal strike price is decreasing in the size of the negative effects of fraud on the company’s value.

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Paper provided by Dipartimento Scienze Economiche, Universita' di Bologna in its series Working Papers with number 542.

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Date of creation: 2005
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Handle: RePEc:bol:bodewp:542
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  1. Siew Hong Teoh & Ivo Welch & T.J. Wong, 1998. "Earnings Management and the Long-Run Market Performance of Initial Public Offerings," Journal of Finance, American Finance Association, vol. 53(6), pages 1935-1974, December.
  2. Burns, Natasha & Kedia, Simi, 2006. "The impact of performance-based compensation on misreporting," Journal of Financial Economics, Elsevier, vol. 79(1), pages 35-67, January.
  3. Degeorge, Francois & Patel, Jayendu & Zeckhauser, Richard, 1999. "Earnings Management to Exceed Thresholds," The Journal of Business, University of Chicago Press, vol. 72(1), pages 1-33, January.
  4. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563 Elsevier.
  5. Michael C. Jensen, 2004. "The Agency Costs of Overvalued Equity and the Current State of Corporate Finance," European Financial Management, European Financial Management Association, vol. 10(4), pages 549-565.
  6. Brian J. Hall & Kevin J. Murphy, 2000. "Optimal Exercise Prices for Executive Stock Options," NBER Working Papers 7548, National Bureau of Economic Research, Inc.
  7. Michael C. Jensen, 2003. "Paying People to Lie: the Truth about the Budgeting Process," European Financial Management, European Financial Management Association, vol. 9(3), pages 379-406.
  8. Angelo Baglioni & Luca Colombo, 2009. "Managers' Compensation And Misreporting: A Costly State Verification Approach," Economic Inquiry, Western Economic Association International, vol. 47(2), pages 278-289, 04.
  9. Brian J. Hall & Kevin J. Murphy, 2003. "The Trouble with Stock Options," NBER Working Papers 9784, National Bureau of Economic Research, Inc.
  10. Brian J. Hall & Kevin J. Murphy, 2003. "The Trouble with Stock Options," Journal of Economic Perspectives, American Economic Association, vol. 17(3), pages 49-70, Summer.
  11. Bergstresser, Daniel & Philippon, Thomas, 2006. "CEO incentives and earnings management," Journal of Financial Economics, Elsevier, vol. 80(3), pages 511-529, June.
  12. Teoh, Siew Hong & Welch, Ivo & Wong, T. J., 1998. "Earnings management and the underperformance of seasoned equity offerings," Journal of Financial Economics, Elsevier, vol. 50(1), pages 63-99, October.
  13. Baruch Lev, 2003. "Corporate Earnings: Facts and Fiction," Journal of Economic Perspectives, American Economic Association, vol. 17(2), pages 27-50, Spring.
  14. Konan Chan & Louis K. C. Chan & Narasimhan Jegadeesh & Josef Lakonishok, 2006. "Earnings Quality and Stock Returns," The Journal of Business, University of Chicago Press, vol. 79(3), pages 1041-1082, May.
  15. Goldman, Eitan & Slezak, Steve L., 2006. "An equilibrium model of incentive contracts in the presence of information manipulation," Journal of Financial Economics, Elsevier, vol. 80(3), pages 603-626, June.
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