Do Equity Incentives Drive Executives to Fudge Their Financials? Who Cares? - www.purelybusinessnews.com - June 24, 2008

www.purelybusinessnews.com/2008/do-equity-incentives-drive-executives-to-fudge-their-financials-who care

Do Equity Incentives Drive Executives to Fudge Their Financials? Who Cares?

According to a 2005 research study,
executives with equity incentives (stock options and restricted stock
grants) were more likely to “smooth” earnings so that they met or
barely beat analysts’ projections. And the longer the continuation of
the equity incentive plan, the greater the “management” of earnings.

The researchers summarized the reasoning behind the behavior this
way: as executives’ wealth became concentrated in one holding (various
forms of their own stock), the incentive to reduce the risk/volatility
of that investment increased dramatically, both psychologically and in economic terms.
The natural human reaction to a perceived risk is to take action to
reduce that risk. In the case of equity-based incentives, executives
have two options:

1. Liquidate the concentrated investment to allow diversification


2. Manipulate earnings to maximize ongoing stock performance

Note carefully my wording. The goal is not a one-time earnings
windfall. Selling after one of those would attract too much of the
wrong kind of attention. The goal is to imitate Jack Welsh and GE and
hit the earnings projections quarter after quarter so that analysts can
make ‘prescient’ projections quarter after quarter and everyone is
happy.Or are they?

Which begs the BIG QUESTION:

Is this:

1. Virtuous behavior by corporate executives


2. A victimless crime


3. An outrage that must be redressed

Before you pass judgment, let me summarize the arguments for each position.

1. Equity incentives are designed to focus executives like a laser
   beam on increasing shareholder value. The data clearly shows that this
   theory works in practice!


2. So what if executives fudge the books a little? Who cares? Not
   their families, who have already calculated the value of those
   options/shares and applied them to future vacations. Not the company
   board members, who are also heavily leveraged in company stock. They
   have the very same risk profile and are likely to See No Evil. Not the
   analysts who make those earnings projections. All market data aside,
   who wouldn’t want to be told on a regular basis “you’re absolutely
   right, you genius!”? And finally, not the employees in the employee
   stock purchase program. I must admit that after examining the issue
   theseprograms are the most ingenious and effective hush money ever
   spent! Corporate employees have access to all the incriminating data,
   but if the ESPP shows a significant profit they’ll all cheerfully
   whistle past the graveyard on the way to the bank. After all, they
   worked for it!


3. This is an outrage that must be redressed! Unfortunately for all
   the beneficiaries of these “benign misdemeanors”, there’s this thing
   called the “slippery slope”. Maybe one quarter you delay booking a
   couple of deals. Or shuffle expenses from one unit to another. Then
   suddenly there’s a suitor at your door so you “miss” your revenue and
   profit targets by “oh so little” and you don’t have to pay out that big
   bonus pool to your employees. And that pile of cash you reserved is now
   looki ng pretty on your financials. Everyone is happy at the
   acquisition closing, but the truth soon reveals itself and mass layoffs
   and stock price swoons ensue. Speaking hypothetically, of course.

So what do you think?

UPDATE: Wow! Great responses! Check this one out:

“Who gets hurt? Interesting question. As a former Enron
executive, I can assure everyone that the stakes are very high indeed.
In the Enron, MCI and other famous cases, billions of dollars and
thousands of jobs were sacrificed on the altar of quarterly earnings.
Most cases of earnings management end less dramatically than those
famous cases but the principle (or lack thereof)are the same - it is
like smoking - highly addictive and always fatal but over an always
uncertain time frame.”

Bravo, Mike! That is my experience, and I think it’s
epitomized in Sir Walter Scott’s famous quip “Oh, what a tangled web we
weave, when first we practise to deceive”. So for at least 400 years
people have instinctively recognized the shady side of earnings
managment!