Incentives and executive behavior
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by Connie D. Weaver |
If you’ve read the book Freakonomics by Steven Levitt and Stephen Dubner, then you’ll have discovered the strange behaviors that result from incentives. Incentives are generally used to encourage certain behaviors. For example, firms use stock options to motivate executives and other employees to improve performance and as a retention tool. However, often the incentives put in place to encourage good performance also promote unintended managerial behavior. Some of my recent research deals with understanding the managerial behaviors driven by incentives such as stock options or managerial evaluation and assessment processes.
In the first paper, my co-authors (Mary Lea McAnally and Anup Srivastava) and I investigate whether large stock option grants drive managers to engage in downward earnings management to miss important earnings targets. Missed earnings targets have been documented to precipitate large negative price reactions. So, while missed earnings targets may be costly to shareholders, executives can benefit via a lower strike price on options granted after a missed earnings target. Our results show that firms that manage earnings downward are more likely to miss earnings targets when they have larger subsequent stock option grants. Thus, although stock option grants may encourage intended behaviors (i.e., better future performance), they also provide an incentive for opportunistic behavior in the short term to the detriment of shareholder value.
In a separate paper, my co-authors (John Robinson and Stephanie Sikes) and I examine the causes and consequences of measuring and evaluating firm tax departments as contributors to the bottom line (profit centers) or as cost centers. Recent anecdotal evidence shows that during the 1990s some managers began to view tax planning as a tool for increasing reported earnings. These managers recognized that certain actions would simultaneously reduce taxes and increase reported earnings. As an example:
“Enron looked to its tax department to devise transactions that increased financial accounting income. In effect, the tax department was converted into an Enron business unit, complete with annual revenue targets. The tax department…then designed transactions…with the primary purpose of manufacturing financial statement income”
(U.S. Congress 2003).
We use confidential survey data from chief financial officers related to the management of their firms’ tax functions and find that profit center firms are positively associated with common measures of tax and financial reporting aggressiveness. These results show another example of how incentives may drive managers to extreme behaviors not originally intended by the implementation of the incentive.
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