Academic journal article Economic Inquiry

Managers' Compensation and Misreporting: A Costly State Verification Approach

Academic journal article Economic Inquiry

Managers' Compensation and Misreporting: A Costly State Verification Approach

Article excerpt


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. …

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