Gaming the System

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- CEO bonus and stock option incentives

A cash bonus plan is linked to earnings which provides the CEO with an incentive to misstate earnings ( ). Moreover, a CEO recompensed hugely by salary has less incentive to misstate earnings. To conclude, CEOs who have a large amount of stock and bonus based compensation relative to their base salary are more likely to misstate earnings.

- Default on debt covenants

According from the research by DeFond and Jiambalvo (1994), default on debt covenants can cause a wealth transfer from stockholders and stock option holders to debt provider if the agreement is renegotiated or debt must pay off immediately. Moreover, if a firm is close to default on accounting-based debt covenants, CEO may misstate the accounting numbers to avoid the consequences of default. In order to measure debt covenant constraints, they use leverage and interest coverage. The result shows that leverage is significant in explaining the accounting policy of restatement firms ( ).

- Raise additional capital

In order to raise additional capital, the firm has an ability to raise new debt and equity capital and the cost of new capital depend on financial health, which is evaluated by accounting numbers. It provides the CEO with an incentive to misrepresent the firms’ financial health to capital providers by misstating accounting numbers. It can cause a transfer of wealth from the new providers of capital to current stockholders and soon to a CEO with in-the-money options. One of the research conducts that an important reason for earning manipulation that engage in fraud is the desire to attract low cost external funding ( ).

- Make an acquisition

“ … makes acquisitions to con the market into believing that management is going to create the value that the market expects, and is able to continue to fool it for some period of time by providing the illusion of growth”

CEO is planning an acquisition that overstated the earnings to inflate the stock price in order to reduce the number of shares required for a stock based acquisition or to increase the proceeds from selling stock to finance a cash acquisition. Moreover, merger-related accounting practices are direct causes of restatements. For example, one of the research by Palmrose and Scholtz (2004) found that merger-related items are the most frequent type of non-core earnings misstatement such as reducing an excessive write-off of in–process R&D. As a result, we assume that during the earliest year restated, firms were more likely to make an acquisition.