What Incentivizes Managers to Engage in Financial Misreporting? An Analysis of Stock Delta, Option Delta and Vega

• In Event: Earnings Management and Information Asymmetry

Abstract

Previous research has used the aggregate delta of the manager’s equity portfolio including both stock and option holdings to measure equity incentives, but documented mixed evidence on the relation between equity incentives and financial misstatements. We hypothesize and find that the mixed results are attributable to the measurement error in aggregate delta because option compensation causes a manager’s incentive structure to be convex while stock compensation makes it linear. Splitting the portfolio delta into stock delta and option delta, we provide evidence that option delta has a dominating effect over stock delta and vega in explaining the likelihood and extent of financial misstatements. We also find that the positive association between option delta and misreporting variables is mainly driven by the effect of CEO’s option delta rather than that of CFO’s. Our findings contribute to the literature by revealing the differential effects of stock delta, option delta, and vega on providing managers with incentives for financial misreporting.

Authors

• Jay Junghun Lee, University of Massachusetts-Boston

• Bo Xu, University of Massachusetts Boston