Out-of-equilibrium CEO Incentives, Dynamic Adjustment and Financial Misreporting

Robert Bushman, Zhonglan Dai and Weining Zhang

Abstract

The objective of this paper is to investigate (1) the role of adjustment costs in sustaining divergence between actual and optimal CEO equity incentives; (2) the nature of the dynamic process governing adjustment of non-optimal incentives back towards optimal; and (3) the extent to which deviations from optimal incentives exacerbate financial misreporting. Consistent with adjustment costs driving a wedge between realized and optimal incentives, we document that firm value decreases in deviations from optimal, and that firms only partially close the current gap between target and actual CEO incentives over the subsequent year. Further, speed of adjustment towards optimality varies with differences in monitoring intensity, product market competition and CEO tenure. Examining consequences of out-of-equilibrium incentives, we find that financial misreporting is increasing in the deviation from optimal, where the sensitivity of misreporting to deviation is stronger when CEO incentives are excessive relative to when they are below optimal levels. Finally, the sensitivity of misreporting to deviation is lower for firms with higher monitoring intensity, and magnified for firms with more intense product market competition and early term CEOs.

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February 19, 2020

Dear all students, staff and members of the CKGSB community,

As the public health emergency caused by COVID-19 is still ongoing, I hope you are all staying safe and healthy. The safety of our staff and students are our top priority at this point, which is why all staff members will work remotely for the time being. In addition, we will offer online learning to our students, in order to continue our curriculum offering, and provide a series of webinars for the wider community on relevant topics.

Fundamental to the core of Cheung Kong Graduate School of Business’ (CKGSB) vision is to cultivate transformative business leaders with a strong sense of social responsibility. To this extent, I’m extremely proud to see the CKGSB community coming together in recent weeks to provide support through donations big and small. Meanwhile, our professors are examining the economic and social impact of the virus and will continue to release data and analysis in the coming weeks.

We will continue to support relief efforts and work together with government agencies, private corporations and international organizations in a meaningful way. Our thoughts and wishes are with all of the people affected by the COVID-19.

Sincerely,

XIANG Bing
Founding Dean
Professor of China Business and Globalization
Cheung Kong Graduate School of Business