Perverse Incentive Effects
EXECUTIVES BEHAVING BADLY
In previous chapters, we saw that incentive structures built into executive compensation often achieve the goal of encouraging, or even inducing, executives to act in a manner that benefits their firms, even if such behavior contrasts with the policies the executives would choose in the absence of those incentives. For example, in chapter 6 we explored the risk-taking behavior of CEOs and found that CEO incentives were often structured to encourage a higher level of risk than that at which the firms had previously operated. (Of course, this increase in risk that firms desire and achieve may not be beneficial from a social point of view, but that is a challenge to corporate governance and firm management that goes beyond gauging the effectiveness of incentives in achieving their intended effects.) While incentives certainly work in general, we documented that they can have less desirable consequences as well.
By contrast with the somewhat mixed story of incentives in previous chapters, this chapter focuses on incentives associated with deceit, crimes, and the destruction of firm value. The two main categories of bad behavior that form the topic of this chapter are what we call “option games” and “earnings management.” Both monikers are intended as ironic understatements.
In brief, option games occur when executives fabricate corporate records concerning the date when options were issued. As we will see, simply changing the date of record for an option grant can bring a CEO a huge windfall. In most instances, this misrepresentation involves criminal, fraudulent reporting to the key stakeholders of the firm, to the public, and to the federal government.
Earnings management occurs when firms adjust their earnings reports from a consistent and straightforward basis to achieve some benefit, or more typically to avoid a stock price downturn that would result from announcing unfavorable news. Earnings management has been an endemic problem in accounting for as long as there have been public companies, and the motivation has often been the general one of simply not wanting to deliver bad