Reducing CEOs' Option-based Compensation Decreases Risky Investments

A recent University of Missouri study provides evidence that decreasing stock option-based compensation of chief executive officers (CEOs) after companies' earnings restatements results in a decrease of risky investments and improved profitability.

"While stock options can be used to persuade mangers to take risky positive projects, high levels of options can induce excessive risk-taking in investment decisions," said David B. Farber, assistant professor of accountancy in the MU Robert J. Trulaske, Sr. College of Business. "When these investments do not produce net positive returns, managers may engage in earnings management to mask underperformance. This can ultimately result in a restatement."

In the study, Farber analyzed 289 firms that had earning restatements from 1997 to 2001. An earning restatement occurs when companies revise their earnings from what they previously reported, because of accounting irregularities or errors. Farber found that compared to other firms, firms that restated earnings were more likely to re-contract with their CEOs after the restatement and reduce the proportion of CEOs' total compensation that was stock option-based. After this reduction, the firms experienced a decrease in risky investments and improved operating performance, resulting in a better bottom line.

"It's easy for the well-intended CEO who has too many stock options to take risky investments," Farber said. "The research results strongly support that a decrease in option-based compensation reduces CEOs' incentives to take excessively risky investments, resulting in improved profitability."