Pay-for-performance Sensitivity of CEO Equity Compensation and Financial Misreporting: Evidence from the Personal Wealth Pursuit Motive of CEOs

The incentive effect of CEO portfolio delta (i.e., the sensitivity of CEO wealth to changes in stock price) on financial misreporting is inconclusive given a complex reward-risk tradeoff faced by CEOs (e.g., a positive “reward effect” versus a negative “risk effect”). We propose that the prevalence of CEO hedging pushes the tradeoff more in favor of the “reward effect” side, resulting in a positive net incentive effect of CEO portfolio delta on misreporting. As the tradeoff is associated with a CEO’s explicit focus on personal wealth, we extract unstructured data from the Accounting and Auditing Enforcement Releases (AAERs) for the sample period 20042016 to identify misreporting driven by a CEO’s wealth-pursuing motive. We document that such misreporting is not only widespread in the sample but also positively explained by CEO portfolio delta. Consistent with our theoretical framework, we find that CEO hedging opportunities moderate the positive relationship between CEO portfolio delta and wealth-pursuing misreporting. We also use a simulation to illustrate how including misreporting cases not associated with the reward-risk tradeoff in the analysis might account for the mixed evidence of the delta-AAER association documented by prior studies. Our findings have important implications for compensation design and corporate governance policy.