According to a two-and-a-half year study conducted at the Robert H. Smith School of Business at the University of Maryland, firms that violate accounting rules are more likely than their peers to provide extravagant stock options to their CEOs, to have history of making numerous acquisitions, and to have younger CEOs.
The study looked at 71 companies subject to SEC enforcement action for alleged accounting violations between 1992 and 1999.
Each of these "violator" companies was then compared to a "meticulously matched" industry peer that had not been accused of accounting irregularities.
(Editor's Note: CW inquiries to Carmelita Troy, who conducted the research, and a Smith School of Business spokesperson regarding the definition of "meticulously matched" were not returned before press-time, and details on the survey are not being released to the public until the Academy of Management annual meeting in Seattle next month.)
The Options Connection
HIGHEST OPTION VALUE/CASH COMP.
Violator
Options/Cash
Non-Violator
Options/Cash
Company L
36.884
Company LL
20.580
Company M
29.598
Company MM
3.240
Company H
28.953
Company HH
0
Company N
26.039
Company NN
0
Company P
16.793
Company PP
0
Regarding the connection between violations and stock options, the study found that violator firms' CEOs on average had options valued at more than three times the CEO's cash compensation, compared to the non-violator firms, which were valued roughly the same as the cash compensation.
At the high end of the violator firms, the options were valued at 30 to 35 times the amount of the cash compensation the CEO received.
Naval Postgraduate School assistant professor Carmelita Troy, who conducted the research for her doctoral dissertation at the Smith School of Business, said, "With such large amounts of the CEOs' personal wealth tied to company stock price, the incentives for overstating profits and financial condition is clear."
Acquisitions
VIOLATORS WITH MOST ACQUISITIONS
Violator
Acquisitions
Non-Violator
Acquisitions
Company A
21
Company AA
0
Company B
14
Company BB
0
Company C
11
Company CC
2
Company D
10
Company DD
3
Company E
6
Company EE
4
The study also found "striking similarities" with regard to the acquisition strategies of the CEOs at violator firms when each was compared their non-violator peers.
The violator firms, on average, made two acquisitions in the three years prior to the alleged accounting violation, compared to an average of only one by the non-violator firms during the same period.
Some violator firms made well over 10 acquisitions, and as many as 20.
The maximum number of acquisitions made by the non-violator, control firms was seven.
CEO Age
VIOLATORS WITH YOUNGEST CEOs
Violator
CEO Age
Non-Violator
CEO Age
Company F
32
Company FF
54
Company G
34
Company GG
43
Company H
35
Company HH
65
Company J
35
Company JJ
57
Company K
35
Company KK
54
Also, the CEOs at the violator firms tended to be younger, with nearly 24 percent of them under the age of 45, compared to just over 14 percent under the age of 45 at the non-violator companies.
The study authors believe there is a close link between acquisition strategies, CEO age, and violations.
"We find inexperienced decision makers attempting to grow the firm through acquisitions," said Scmith School professor and study co-author Ken G. Smith. "The negative consequences of these acquisitions in terms of cash flow — which may be putting pressure on stock prices, along with dependency on stock options — may be driving CEOs to make up their own numbers."
Smith School professor Larry Gordon agrees. "The research shows that an environment of excessive stock options and deteriorating corporate financial condition, preceded by a history of growth through acquisitions, provides conditions ripe for accounting violations."
Audit Committee Connections
The research also found that compared to the non-violator firms, the audit committees of the violators' firms had more directors who were either employees of the firm, did significant business with the firm, or were otherwise affiliated with the firm in ways that interfered with their independence from management.
That behavior is now banned under Sarbanes-Oxley — audit committee members can not have ties to the company that lead to a conflict of interest that hinders the audit committee from discharging its duties.
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