CEO Pay and Fruad

Academy of Management Journal
2006, Vol. 49, No. 3, 483500.
DO CEO STOCK OPTIONS PREVENT OR PROMOTE

FRAUDULENT FINANCIAL REPORTING?
JOSEPH P. OCONNOR, JR.
University of Texas at El Paso
RICHARD L. PRIEM
University of WisconsinMilwaukee
JOSEPH E. COOMBS
Texas A&M University
K. MATTHEW GILLEY
Oklahoma State University
We contrast the conventional view that CEO stock options aid corporate governance by
reducing moral hazard with the proposal that CEO stock options may subvert sound
corporate governance. Views were tested in 65 matched pairs of public U.S. firms that
either had or had not been discovered misreporting financial results. Our results
support both the traditional perspective and our unprincipled agent view: in our
sample, large CEO stock option grants were sometimes associated with a lower incidence of fraudulent reporting and sometimes with a greater incidence, depending upon
whether CEO duality was present and whether directors also held stock options.
ment research has yet to link even widely prescribed governance mechanisms with this most
basic decision: to strive to report financials accurately. Stock option grants to CEOs are one accepted corporate governance mechanism that,
along with appropriate monitoring, should induce CEOs to make decisions consistent with
long-term shareholder wealth maximization (Beatty & Zajac, 1994). Yet a key governance issue
remains: how do CEO stock option grants influence firms subsequent likelihood of malfeasance
in financial reporting?
In this article, we first discuss several agency
theory (Jensen & Meckling, 1976) prescriptions
for corporate governance that are intended to prevent or minimize harm to shareholders. Second,
we argue that prescriptions for CEO and board of
directors stock options can, when carried to extremes, promote harmful behavior by unprincipled agents. Third, we develop a model that contrasts agency theorys incentives alignment logic
with options-based temptations for unprincipled
agents, in the context of financial reporting accuracy. Fourth, we report tests of our model using a
matched-pairs analysis of firms that did and did
not engage in fraudulent financial reporting. Finally, we discuss the implications of our results
for practitioners and scholars interested in corporate governance.
Accurate financial reporting by listed firms is

essential for viable equity markets. Yet recently,
fraudulent financial reports have damaged the
U.S. economy, contributing to $7 trillion lost by
U.S. pension plans and 401(k) savings plans from
2000 to 2002 (Siebert, 2002). These intentional
financial misstatements by corporate managements have led some scholars to question the
legitimacy of shareholder return as the core value
governing corporations and to argue instead for
approaches that maximize other stakeholder benefits or aggregate societal welfare (Child, 2002;
Kochan, 2002). Others, however, continue to focus on shareholder return, searching for effective
corporate governance mechanisms that minimize
moral hazard in the management-shareholder
relationship.
Unethical or illegal behavior, particularly that
involving financial reporting, erodes shareholder
value. Sound corporate governance therefore
must include, at the very least, the decision to
eschew fraud in financial reporting. But manage-
We thank Paul Clikeman, Tim Haas, David North, Paul

Nystrom, Ehsan Soofi, and the members of the University
of WisconsinMilwaukee Doctoral Seminar in Organization Theory for helpful comments on earlier versions of
this article, and Jeff Vanevenhoven for data-gathering
assistance.
483
484
THEORETICAL BACKGROUND
Early studies of corporate illegal activity, which
they labeled white-collar crime, focused on individual business people who bribe, embezzle, or
misappropriate funds, manipulate stock exchanges,
misrepresent financial statements, misleadingly
advertise, and so on (Sutherland, 1940; Tappan,
1947). Later white-collar crime studies emphasized
illegal acts committed for corporate gain rather
than individual gain (e.g., Sutherland, 1956). More
recent studies have distinguished between corporate and individual criminality by identifying the
beneficiaries: companies benefit from corporate
crimes, while individuals achieve personal gain
through individual crimes (Baucus, 1994; Daboub,
Rasheed, Priem, & Gray, 1995; McKendall & Wagner, 1997; Schrager & Short, 1978).
The various well-known corporate financial
frauds that occurred in the United States in the
early 2000s generally involved inaccurate or misleading financial statements intended to maintain
the appearance that a company continued to generate high earnings. The specific techniques varied:
serial acquirers manipulated postacquisition
earnings with each purchase; trading companies
engaged in round tripping to boost revenues;
some firms used off-balance-sheet entities for financing; and so on. The consistent goal, however,
was to meet Wall Street expectations and thereby
keep stock prices high. This contrived elevation of
stock price benefited executives in the near term by
calming performance pressure and, often, by allowing the sale of stock options at artificially inflated
prices. In many cases, the firms themselves were
obvious victims, ultimately filing for bankruptcy to
avoid liquidation after their stock prices finally
crashed. Employees, their 401(k)s and pension
funds, local communities, and investors all also
suffered. Clearly, these frauds failed to benefit the
firms involved, but they often instead rewarded
individual top managers, many of whom shared a
common possession: large blocks of stock option
grants that could be exercised in advance of negative information.
Principal-Agent Theory and Moral Hazard

Berle and Meanss (1932) seminal study of the
largest 200 U.S. public corporations highlighted the
separation between shareholders, who supply capital and bear risk, and managers, who control firms.
They aptly noted that the struggle for corporate
control revolves around the desire for personal
gain. Differing viewpoints subsequently have developed concerning (1) the status of shareholders as
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firm owners and (2) the proper role of a firms board

of directors. Some researchers (Berle & Means,
1932; Jensen & Meckling, 1976) have viewed shareholders as owners. Others (Alchian & Demsetz,
1972; Fama, 1980) have seen shareholders as investors rather than owners, because others already
own firms resources through the nexus of individual contracting relationships that comprise each
firm (Coase, 1937). Shareholders as investors benefit through limited liability, unrestricted share salability, and voting authority in ways owners would
not (Alchian & Demsetz, 1972). Similarly, although
Berle and Means (1932) saw directors as members
of management serving in a fiduciary capacity,
other scholars (Finkelstein & Hambrick, 1996) normatively viewed board members as agents for firmspecific resource owners such as shareholders,
creditors, employees, and customers. Nonetheless,
consensus has developed concerning the central
role of moral hazard in corporate governance issues
(Foss, 1996a).
Moral hazard occurs when managers, acting as
agents for shareholders, behave in ways that reduce shareholder value (i.e., are against the principals interests). Arrow (1971a) likened equity
ownership to a managerial insurance policy, because equity distribution allows managers to
shift some of their firms risk to shareholders.
Arrow (1971b) then extended the insurance industrys concept of moral hazardwherein an
insurance policy can induce undesirable behaviors, such as insuring real estate assets in
amounts that exceed their value and then committing arsonto the situation of corporate control. Some major categories of executive moral
hazard cited in the literature include asset expropriation by selling below market rates (Shleifer &
Vishny, 1997); misstatements and nondisclosures
that place nonmanagement shareholders at a disadvantage (Berle & Means, 1932); consumption of
costly perquisites (Jensen & Meckling, 1976); pursuit of personal objectives, such as increased
compensation, through diversification and
growth ventures that misuse free cash flow
(Jensen, 1986); foregoing investments in projects
that have positive net present values, to avoid the
risk of unemployment if the projects fail (Denis,
2001; Finkelstein & Hambrick, 1996); and extraordinary efforts to remain in power by fighting
takeover attempts that might benefit shareholders
(Shleifer & Vishny, 1997). In the face of these
possibilities for moral hazard, one of principalagent theorys key contributions has been its prescriptions for effective corporate governance.
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OConnor, Priem, Coombs, and Gilley
Corporate Governance
Corporate governance attempts to mitigate moral
hazard problems. Jensen (1993) argued that four
forces operate to promote effective governance: legal and regulatory systems; external control mechanisms, such as capital markets, that allow companies to be taken over; product and factor markets;
and internal control systems headed by boards of
directors. Legal and regulatory systems include
monitoring in the form of external regulatory oversight as well as bonding through debt and bankruptcy. External control mechanisms encompass
the capital markets ability to handle liquidations
and takeovers, the ultimate discipline for failure to
maximize shareholder value (Fama, 1980). Product
and factor markets include competition for firms
products and services and the discipline of the
external and internal managerial labor markets (Alchian & Demsetz, 1972; Fama, 1980). Internal control systems encompass board activities, plus executive compensation, stock options, and ownership
interests, all intended to align managers desire for
personal gain with the similar motivation of shareholders (Denis, 2001; Jensen & Meckling, 1976;
Shleifer & Vishny, 1997).
HYPOTHESES
We focus on CEO incentive compensation, in the
form of stock option grants, as a major element of
the corporate control system, because (1) incentive
compensation often is seen as a vital component of
sound corporate governance systems (Denis, 2001;
Jensen & Murphy, 1990); (2) stock options are very
common for CEOs (Knight, 2002); (3) CEOs are key
actors whose perceptions and actions influence
their firms capabilities and, ultimately, firm-level
performance (e.g., Daft, Sormunen, & Parks, 1988;
Priem, 1994); (4) the value of other top executives
stock options incentives is often linked to the value
of their CEOs stock options; and (5) CEO stock
options are visible to all firm stakeholders through
public records, such as the firms proxy statement,
and thereby can represent a concrete signal for
stakeholders that the goal of the firms CEO is increasing shareholder value. We first develop competing hypotheses concerning the potential effects
of CEO stock option compensation on the likelihood of fraudulent financial reporting. We then
suggest that the strength of these effects is enhanced when either CEO duality1 or board stock
CEO duality occurs when a single individual serves

as both the CEO of a company and the chair of its board
of directors.
485
option compensation is also present, and that this

enhancement is greatest when both occur
simultaneously.
Two Views of Incentive Compensation and
Fraudulent Financial Reporting
Jensen and Meckling (1976) introduced the notion of aligning managers interests with those of
shareholders, and thereby reducing moral hazard,
through the use of incentive compensation. Such
outcome-based incentive contracts shift risk from
shareholders to management (Arrow, 1971a; Eisenhardt, 1989). Most agency theorists now recommend that corporations supplement board of director monitoring by using equity-based incentives,
such as stock options, to align management interests with those of shareholders (Gomez-Mejia,
1994; Jensen & Murphy, 1990).
Despite the popularity of stock options as ostensibly free compensation (Knight, 1998), they
have five well-known shortcomings. First, uncontrollable stock market changes often have more influence on a firms stock price than do the operating decisions that the firms CEO can control.
Second, investor expectations similarly have a
large effect on stock prices. Third, management
decisions that increase short-term stock price often
do not benefit shareholders in the long term.
Fourth, management stock options do not share
downside risk with the actual shares held by shareholders. And fifth, managements influence over
stock price is limited to affecting operating performance, which is only one factor among others
(such as investor expectations and discount rate) in
a firms overall stock price (Knight, 1998, 2002).
Despite these shortcomings, stock options are a
popular mechanism for aligning managers and
shareholders interests. In a 2001 survey of 350
major U.S. companies, Mercer Human Resource
Consulting found that gains from exercising stock
options provided 70 percent of median CEO total
direct compensation, comprised of salary, bonus,
restricted stock, stock option exercise gains, and
long-term incentive payouts (Lublin, 2002) and set
the ceiling for the rest of these firms compensation
structures (Gomez-Mejia, 1994). According to the
traditional tenets of agency theory, increases in
CEO stock options, along with effective monitoring,
produce better alignment between the interests of
management and shareholders. That is, both CEOs
and shareholders benefit from rising long-run stock
prices, thereby reducing the likelihood of moral
hazard. Moreover, positively valued stock options
create risk for CEOs (Wiseman & Gomez-Mejia,
1998). Risk is created because CEOs with positively
486
valued stock options have a good deal to lose personally in the event of negative financial news, and
an unexpected downward restatement of financial
results is among the worst possible financial news
a firm and its CEO can receive, especially from a
stock options value perspective. Therefore, CEOs
with stock options will strive to ensure the legitimacy of their accounting practices. Thus:
Hypothesis 1a. The higher the value of a CEOs
stock options, the lower the likelihood of
fraudulent financial reporting.
CEOs are sometimes faced with moral dilemmas,
wherein pursuit of their own self-interest will
cause harm to others over which the relevant others
have no control (Hosmer, 1994). We label as unprincipled agents those managers who willfully
take actions that benefit themselves while negatively affecting potential shareholder value maximization. Unprincipled agents facing moral dilemmas engage in opportunistic behavior (Foss, 1996a,
1996b; Gottfredson & Hirschi, 1990) if they have
both the incentive and opportunity to do so
(Coleman, 1995). The key question for corporate
governance is not whether a specific agent is principled or unprincipled; many principled CEOs
likely would behave in the shareholders interests
even when offered considerable incentive and opportunity to do otherwise. Instead, the question is
whether or not in the presence of an unprincipled
agent a particular control mechanism will either (1)
eliminate the moral dilemma by aligning the interests of all parties or (2) monitor the unprincipled
agent closely enough to ensure that there will be no
opportunity for self-interested behavior to occur.
Ideally, according to principal-agent theory, CEO
stock options eliminate moral dilemmas by aligning CEO interests with those of shareholders (although they may not perfectly do so) and, therefore,
continued board of director monitoring is necessary. Next, we argue that, contrary to agency theory,
stock options can actually exacerbate the moral
hazard facing CEOs by providing extra incentive for
self-interested behaviors. That is, when opportunity is present, options will increase the likelihood
of self-interested behaviors by unprincipled CEOs,
ultimately harming shareholders.
Incentive. The accounting literature provides
empirical evidence that CEOs have financial incentives to continually maintain or increase firm performance and to avoid lower-than-expected performance. For example, Payne and Robb (2000),
Brown (2001), and Matsumoto (2002) demonstrated
that managers act to avoid negative earnings surprises. Matsunaga and Park (2001) showed that falling short of quarterly earnings forecasts or of earn-
June
ings for the same period in a prior year adversely

affected CEO cash bonuses. Further, Boschen,
Duru, Gordon, and Smith (2003) demonstrated that
unexpectedly good stock performance positively
affected CEOs long-run cumulative financial gains.
Thus, recent empirical studies have shown that
CEOs have much to lose financially if their firms
underperform relative to expectations and have
much to gain financially if their firms overperform.
Opportunity. No matter how strong the incentive, however, unethical or illegal actions cannot
take place without opportunity. If firms compete in
dynamic, deregulated markets where successful
firms make the rules of the game, and if these
firms pursue diversified growth strategies with
complex structures and decentralized controls, opportunities increase for unprincipled agents to engage in opportunistic behaviors (Baucus & Near,
1991; Daboub et al., 1995; McKendall & Wagner,
1997; McKendall, Sanchez, & Sicilian, 1999). Actions contrary to shareholders interests are particularly difficult to detect when they involve judgment calls by the managers, such as CEOs, who are
expected to be the most knowledgeable about firms
and their activities (Jensen & Meckling, 1976). Decisions concerning aggressive accounting practicesin particular, financial misstatements designed to manipulate stock prices, misappropriate
funds, or facilitate insider tradingare judgments
in which wrongdoing is particularly hard to identify. In such situations, the opportunity for selfinterested action is present, and increases in CEO
stock options simply raise the incentives for such
action and lead to a higher incidence of fraudulent
financial reporting.
This line of reasoning is consistent with research
in accounting investigating the general hypothesis
that compensation plans can motivate CEOs to
make self-serving or even fraudulent decisions. For
example, Barton (2001) found evidence in a sample
of Fortune 500 firms that cash compensation was
positively related to the use of earnings management techniques, while the value of stock owned
by a CEO and the number of options held by the
CEO were related to the use of interest rate and
foreign currency derivatives. Barton (2001) concluded that managers were purposely managing
earnings to increase their cash compensation and
using derivatives to increase the value of their
stock-based compensation. In a study of firms preparing for initial public offerings (IPOs) of stock,
DuCharme, Malatesta, and Sefcik (2001) reported
that managers manipulated earnings to increase
proceeds from the IPOs at the expense of investors.
Guidry, Leone, and Rock (1999) and Healy (1985)
provided evidence that earnings management was
2006
associated with CEOs bonuses, and Healy (1985)

further found that bonus plan adoptions and
changes to bonus plans were associated with
changes in earnings management. Hirst (1994)
demonstrated that bonus plans created incentives
for executives to manage earnings in such a way
that their bonuses would be maximized. Furthermore, although Gerety and Lehn (1997) found no
clear relationship between the use of accountingbased management compensation plans, such as
profit sharing, bonuses, and stock options, and instances of accounting fraud, they did determine
that large stockholdings by a single executive reduced the likelihood of fraud. Thus, the accounting
literature provides evidence that executives may
make company decisions designed to maximize
their individual wealth. In other words, executives
may game the incentive system, enabled by the
presence of information asymmetry (Baker,
1992), behaving in ways that increase their own
rewards while reducing their firms performance.
Hence,
Hypothesis 1b. The higher the value of a CEOs
stock options, the higher the likelihood of
The Moderating Effects of CEO Duality and
Board Stock Options
The strength of the proposed competing relationships between the value of CEO stock options and
the incidence of fraudulent financial reporting is
likely influenced by two additional factors: CEO
duality and board stock compensation. CEO duality
has been consistently recognized as a conflict of
interest in corporate governance, in part because it
is also recognized as an indicator of CEO power
(Coles & Hesterly, 2000; Daily & Dalton, 1994;
Finkelstein & Hambrick, 1996). Although board
members are charged with governing firms and ensuring high levels of firm performance, they may
fail to do so effectively in the presence of CEO
duality. CEOs who serve as board chairs gain influence over board member nominations, compensation setting, board agendas, and so forth, even if
they do not formally serve on the committees
charged with those responsibilities. This influence
may compromise corporate governance. Prior research has shown that duality is related to higher
executive compensation (Magnan, St-Onge, &
Calloch, 1999), poison pill adoption (Mallette &
Fowler, 1992), diversification (Zantout & OReillyAllen, 1996), and takeover premiums (Hayward &
Hambrick, 1997). These outcomes may result from
powerful CEOs who are also board chairs circum-
487
venting the governance process in an attempt to

shape their organizations to their liking. Thus,
CEOs who also chair their firms boards will hold
greater power that, in turn, will make it easier for
them to either (1) ensure the shareholders interests
are foremost, under the agency theory argument, or
(2) pursue their own interests unchecked, under
the unprincipled agent argument. Therefore, CEO
duality is proposed to enhance the relationship,
whether positive or negative, between CEO stock
options and accounting irregularities for either of
our competing hypotheses (Howell, Dorfman, &
Kerr, 1986). Hence,
Hypothesis 2. The presence of CEO duality
strengthens the association between the value
of CEO stock options and the incidence of
If board members receive stock options as part of
their compensation, under the principal-agent
viewpoint their interests become more aligned with
those of shareholders. This alignment helps to ensure appropriate monitoring by boards, results in
fewer accounting irregularities (Finkelstein & Hambrick, 1996), and suggests a lower likelihood of
financial statement fraud (Beasley, 1996). Under
the unprincipled agent viewpoint, however, the
board monitoring function, particularly as regards
use of aggressive accounting to prop up a firms
stock price, may be compromised. That is, directors interests are aligned with CEOs interests in
maintaining a high stock price (McKendall et al.,
1999). Therefore, directors monitoring would be
less aggressive and the likelihood of subsequent
fraudulent financial reporting would increase.
Thus, board stock options are proposed to enhance
the relationship, whether positive or negative, between CEO stock options and fraudulent financial
reporting, again for either of our competing hypotheses. Hence, we propose:
Hypothesis 3. The presence of board of director
stock options strengthens the association between the value of CEO stock options and the
incidence of fraudulent financial reporting.
Beyond their individual moderating effects, however, CEO duality and board stock options together
likely have additional, complementary effects on
the relationship between CEO stock options and
fraudulent financial reporting. CEO duality is an
indicator of CEO power, and board stock options
are a sign of board influence. Together, CEO power
and board influence have mutually reinforcing effects. That is, when present simultaneously, they
complement one another to increase the overall
effect on the relationship between CEO stock op-
488
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FIGURE 1
Competing Corporate Governance Hypotheses
tions and fraudulent financial reporting beyond the

individual moderating effects. When incentives for
self-interested behavior are present, for example,
the influence of a powerful, unprincipled CEO is
magnified by an acquiescent board with stock options and, reciprocally, an unprincipled board with
stock options can exercise influence more effectively on a powerful but unprincipled CEO. Conversely, the influence of a powerful but principled
CEO is reinforced by a principled board with stock
options, even in the presence of incentives, and a
principled board with stock options can exercise
influence effectively when the CEO is powerful but
principled. Following these arguments and those
presented for Hypotheses 2 and 3 above, the simultaneous presence of CEO duality, indicating power,
and board stock options, indicating influence,
would either (1) allow powerful, unprincipled
CEOs to pursue their own interests with little interference from coopted boards of directors (e.g.,
McKendall et al., 1999) or (2) allow powerful, principled CEOs to pursue shareholders interests supported by rigorous board monitoring (e.g., Beasley,
1996). Thus, jointly occurring CEO duality and
board stock options are reciprocally reinforcing,
and joint occurrence further enhances the relationship, whether positive or negative, between CEO
stock options and fraudulent financial reporting,
again for either of our competing hypotheses.
Hence, we propose:
Hypothesis 4. The simultaneous presence of
CEO duality and board stock options strengthens the association between the value of CEO
stock options and the incidence of fraudulent
financial reporting, magnifying the individual
moderating effects.
Figure 1 summarizes these proposed relationships. The next section presents our empirical
study of these relationships.
METHODS
Sample Selection
The outcome of interest in our study was intentional financial misreporting that artificially inflated a firms results. Because such fraudulent outcomes were relatively rare events, random
sampling was not feasible, and we instead used a
more powerful matched-pair design. We first identified firms that unambiguously had fraudulently
inflated financial results and then, for each such
firm, we identified a matching firm that had not
done so, as described below.
Firms restating financial results under pressure. We reviewed 12,222 articles using the ProQuest Newspapers database of over 550 newspapers, searching full-text articles that appeared from
January 1, 2000, to June 30, 2004, for variations of
the word restate. The lead author and another
subject expert were trained to identify firms (1) that
had restated their financial accounts downward, (2)
whose misreporting was unrelated to changes in
accounting principles or to nonfinancial matters,
and (3) that restated only after pressure by federal
or state regulatory agencies responding to perceived malfeasance (e.g., an SEC-initiated investigation or a state public service commission order).2
Only firms that unambiguously met all criteria
were included. We focused on restatements made
under pressure from regulatory agencies in order
to exclude the common situation in which federal
and state regulatory inquiries are initiated after restatements occur. In the latter situation, restatements may be the result of effective internal corporate governance practices, and we wanted to limit
our sample to those clearly intentional transgressors that restated only because regulatory agencies
compelled them to do so. An average of 278 firms
The SEC is the U.S. Securities and Exchange

Commission.
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restated annually because of misreporting that excluded changes in accounting principles or nonfinancial matters, but only about 20 annually clearly
restated under pressure. Our review of ProQuest
articles identified 103 firms that met the restatement-under-pressure criterion during the period of
our study, out of an annual average of over 9,600
U.S. independent public firms. Please note that
restatement year, as used here, is the year when a
restatement was made, not the fiscal year for which
results were restated. Firms meeting our requirements for fraudulent financial reporting included
such well-known transgressors as CMS Energy,
Dynegy Incorporated, Qwest Communications International, and Rite-Aid Corporation.
Matching firms. We introduced a number of controls through our matching procedures, employing
eight matching variables: firm independence, public ownership, U.S. citizenship, 1996 2004 time
period, industry (four-digit Standard Industrial
Classification code), 1996 99 average annual net
sales, 1996 99 average net income, and 1996 99
average annual vesting period. We identified close
matches for 65 of the original 103 restated-underpressure firms, and we used multiple approaches to
test the effectiveness of our matching procedures.
The Appendix contains details of the matching procedures and effectiveness tests.
Two key factors that could affect the likelihood
of fraudulent financial reportingindustry and
firm characteristicswere controlled through our
matching procedures. Industry factors that influence white-collar crime include market structure,
resource scarcity, environmental uncertainty, and
regulatory environment. For example, highly concentrated industry structures, resource scarcity,
rapidly changing environments, and recent deregulation have all been found to be antecedents of
corporate illegality (Coleman, 1995; Daboub et al.,
1995; McKendall & Wagner, 1997; McKendall et al.,
1999). These potential sources of variation are controlled through matching by industry, defined by
four-digit SIC code.
Firm size is an important organizational variation that can also influence the likelihood of whitecollar crime. As companies grow, for example, they
become more complex and often decentralize their
operations, giving unprincipled agents more opportunity to commit illegal acts while localizing
awareness of such activities (Baucus & Near, 1991;
Daboub et al., 1995; McKendall & Wagner, 1997;
McKendall et al., 1999). We controlled for firm size
through matching firms by average annual net
sales.
Time periods. In 1996, the Financial Accounting
Standards Board required companies to begin ac-
489
counting for stock-based compensation using the

Black-Scholes option-pricing model (Balsam,
Mozes, & Newman, 2003). Because we judged the
Black-Scholes method to be the appropriate one to
use to value option grants (see Independent variables below), we chose 1996 as the beginning of
the four-year treatment period during which we
measured our independent and control variables.
The four-and-a-half-year outcome period for our
dependent variable was 2000 04 (only the first six
months of 2004 were included). We used multiyear
rather than single-year treatment and outcome periods for several reasons. First, since CEO and
board stock options are not granted every year in
each firm, using only one year would have risked
missing large option grants in the years before or
after the single year chosen. Second, stock options
do not immediately vest, or become exercisable.
Most firms in our study used two- to five-year vesting periods; for example, firms that offer stock options with five-year vesting periods have 20 percent
of the options available for exercise after each year
in a five-year period. Thus, it is necessary to aggregate option grants over a multiyear period to more
accurately reflect CEO and board incentives. Finally, we hypothesized causal relationships
wherein stock options granted affected fraudulent
financial reporting and, subsequently, restatements
under pressure. Thus, a time-lagged model was
necessary, with CEO stock option grants as treatments preceding restatement-under-pressure outcomes in time.
Variables
Dependent variable. The dependent variable
was binary: whether or not a firm restated its financial results downward under pressure from January
1, 2000, through June 30, 2004. We used a binary
dependent variable for two reasons. First, fraudulent financial reporting is an either/or phenomenon, occurring irrespective of the size of the fraud.
Second, when financials have been reported fraudulently, the scope of the fraud is seldom unambiguous, and restatements of restatements often occur. Thus, one cannot accurately or soon determine
either the absolute or relative size of many frauds.
Independent variables. The three main effect
variables were average annual CEO stock options,
board of director stock options, and CEO duality.
Average annual CEO stock optionsthe average
annual value of stock option grants made during
the period 1996 99 were measured in millions of
dollars. We obtained CEO stock option values from
Standard & Poors Execucomp database for 88 of
the 130 firms and from proxy statement data for the
490
remainder. The values were computed using the

Black-Scholes methodology applied to individual
stock option grants (Black & Scholes, 1973). We are
sensitive to criticism that the Black-Scholes
method was designed to price exchange-traded options and not employee stock options, for which no
market exists (Gleckman, 2002). We nevertheless
believed the Black-Scholes method was the most
appropriate for our study because it (1) had been
widely used and validated in prior research (e.g.,
DeFusco, Johnson, & Zorn, 1990; Finkelstein &
Boyd, 1998; Kerr & Kren, 1992; Wright, Kroll, Lado,
& Van Ness, 2002) and (2) would therefore give our
study, which examined an exceptional CEO behavior, comparability with previous studies that examined CEO options and somewhat less extreme
behaviors.3
The question of equity pay for directors bridges
the issues of monitoring and incentive compensation. Hambrick and Jacksons (2000) study provides
one indication of the potential effects of equity or
options incentives for boards of directors. They
found that companies with directors who owned
company stock outperformed other firms. Like CEO
stock options, board stock options may align board
members interests with shareholder interests.
They also may create risk bearing similar to that
experienced by CEOs, however, which may be a
governance benefit not associated with stock ownership. In the present study, the presence of board
stock options was a binary variable coded 1 for
presence and 0 for absence.
CEO duality was also a binary variable indicating
the presence or absence of this additional power.
CEO duality was coded 1 if a firms CEO also served
To convert firm Black-Scholes data, which contained

differing assumptions involving interest rates, stock
price volatility, and grant-to-exercise duration, to the
common assumptions of Execucomp Black-Scholes
data, several steps were required. First, to address industry-varying stock price volatility, we grouped 88 companies for which we had both firm and Execucomp BlackScholes data into five broad industry categories using SIC
codes 13, 4, 5, 6, and 78. Second, to address interest
rate volatility, we constructed four linear regression
models corresponding to the years 199699 for each category, obtaining a total of 20 linear regression models.
For each model, we obtained a significant F-ratio (p
.05, with 19 significant at .01) and an adjusted R2 exceeding .90 in 17 of the 20 models. For each of the 42 firms
without Execucomp CEO stock option values, we then
converted the Black-Scholes data from their proxy statements to Execucomp Black-Scholes equivalents using
the appropriate linear regression equation.
June
as the chair of its board of directors at any time

during the 199699 period; otherwise, it equaled 0.
Statistical control variables. Six control variables were employed in our model: a firms average
annual number of audit committee meetings, average CEO age, the average annual percentage of CEO
stock ownership, the average annual CEO cash
compensation (composed of salary, annual bonus,
long-term incentive plan payouts, and perquisites
such as transportation, housing, tax payments,
etc.), the average annual CEO restricted-stock
award, and the average annual CEO stock ownership market valuation.
Average annual audit committee meetings, a
proxy for board vigilance, was a firm-level control
variable. Although a higher percentage of outside
directors is typically associated with more intensive monitoring by a board (Daily & Dalton, 1994),
we chose to use a finer-grained operationalization
of board vigilance that was particularly appropriate
for assessing financial malfeasance. Schnatterly
(2003), for example, found that the number of audit
committee meetings was negatively associated with
the number of white-collar crimes. An audit committee is the ultimate monitor of a firms financial reporting system (Klein, 2002: 437). External
auditors are required to report both their findings
and their overall assessment of a companys
strengths and weaknesses directly to its audit committee (Cox, Grace, Haupert, Howell, & Wilcomes,
2002), and this committee must meet separately
with the companys senior financial management
and with internal auditors to ensure that management actively manages recognized risks and avoids
misstatements in financial reporting (Braiotta,
2002). Moreover, since December 1999, the New
York Stock Exchange and NASDAQ have required
that audit committees be composed of at least three
independent, outside directors (Klein, 2002).
Average CEO age was included as a statistical
control because of its relationships to managerial
risk propensity and moral judgment (e.g., Child,
1974; Zahra, Priem, & Rasheed, 2005). Average annual CEO stock ownership percentage was used as
an indicator of ownership effects, including alignment with shareholder interests (Jensen & Meckling, 1976; McGuire & Matta, 2003; Miller, Wiseman, & Gomez-Mejia, 2002; Sanders, 2001).
Average annual CEO stock ownership percentage
was measured by the number of shares either
owned or exercisable within 60 days of a firms
proxy statement filing (an SEC reporting convention) divided by the total number of shares outstanding. Average annual CEO stock ownership
market valuation was used to incorporate potential
wealth effects and downside risk, which, according
2006
491
TABLE 1
Descriptive Statistics and Correlationsa
Variable
Mean
s.d.
Case
Average annual audit committee meetings
Average CEO age
Average CEO stock ownership
Average annual CEO cash compensation
Average annual CEO restricted stock
Average annual CEO stock ownership
market valuation
8. Average annual CEO stock options
9. Board of director stock options
10. CEO duality
0.50
3.10
54.12
7.07
1.82
1.65
220.52
0.50
1.98
7.28
13.31
3.00
14.80
1,265.53
.17*
.22*
.01
.01
.10
.04
.26**
.25**
.47***
.02
.03
.15
.19* .14
.00 .02
.03
.22*
4.50
0.72
0.75
11.51
0.45
0.44
.01
.08
.08
.06 .04
.26**
.18 .04 .10
.19* .22* .11
1.
2.
3.
4.
5.
6.
7.
.06
.00
.09
.14
.04
.40***
.07
.08
.13
.07
.07
.09
.05
.06
.06
a
The table displays the means of uncentered variables. (The binary variables were not centered.) The standard deviations, correlations,
and probabilities of the centered and uncentered variables are identical. n 130.
p .10
* p .05
** p .01
*** p .001
to prospect theory (Kahneman & Tversky, 1979),

make CEOs more risk-averse (Sanders, 2001). Sanders (2001) noted, for example, that although CEO
stock options associated with upside potential promote risk-taking behavior, CEO stock ownership
instead promotes risk-averse behavior. Thus, a
higher average annual CEO stock ownership market
valuation may be associated with a lower incidence
of fraudulent financial reporting. Moreover, increased CEO stock ownership wealth is also associated with higher firm performance (Kay, 2004;
McGuire & Matta, 2003). We computed average annual CEO stock ownership market valuation as the
number of CEO-owned, exercisable shares reported
in a firms proxy statement multiplied by the average of the high and low stock prices for each of a
years four quarters, as reported in the firms SEC
Form 10-K Annual Report.
Average annual CEO cash compensation and average annual CEO restricted stock were included as
controls because they represent trade-offs in an
overall CEO compensation packagefor example,
more options for less salaryand thus modify the
relative importance of stock option grants to a
CEOs overall compensation (Sanders, 2001).
DATA ANALYSIS AND RESULTS
We tested our hypotheses using the conditional
(i.e., case-control-matching) logistic regression
model (Agresti, 2002; Hosmer & Lemeshow, 2000)
and general estimating equations, for several reasons. First, in our matched-pairs design each pair
contained one firm in which downward restatement under regulatory pressure occurred and one
in which it did not. Thus, the dependent variable

was binary. Second, the matched-pairs method employs a conditional distribution, with the distribution of Yi fixed (each matched pair has one 1 and
one 0) and therefore subject-specific, instead of
marginally distributed and population-averaged.
And third, general estimating equations are particularly useful for categorical repeated measurements such as these (Stokes, Davis, & Koch, 2000)
and produce robust estimations (Allison, 1991).
There is no overall intercept term in conditional
logistic regression because such a term would interfere with the case-based estimates of the other
parameters (Agresti, 2002).
Table 1 presents the means, standard deviations,
and zero-order correlations for all variables included in our study. Uncentered means are shown,
but we centered all continuous (nonbinary) variables, as Aiken and West (1991) suggested, before
hypothesis testing. Table 2 shows our logistic regression models.
Model 4 is the full, unrestricted model in which
we entered the six statistical control variables,
three main effects for the variables in our hypotheses, and all interaction terms to ensure a rigorous
test of the hypothesized effects. The significance of
the triple interaction term in model 4 indicated that
this term contributed to model significance that
was greater than that of the restricted model 3. The
likelihood ratios comparing the further restricted
models, from which the double interactions (model
2) and main effects (model 1) were also removed,
indicated that the double interaction terms together
and main effect terms together each contributed to
overall model significance and that the full, unre-
492
June
TABLE 2
Results of Conditional Logistic Regression Analysis for Fraudulent Financial Reportinga
Model 4
Variable
Control variables
Average annual audit committee meetings
Average CEO age
Average CEO stock ownership
Average annual CEO compensation
Cash compensation
Restricted stock
Stock ownership market valuation
Main effects variables
Average annual CEO stock options
BOD stock options
CEO duality
Interaction variables
Average annual CEO stock options board of director stock options
Average annual CEO stock options CEO duality
Board of director stock options CEO duality
Average annual CEO stock options board of director stock options
CEO duality
Scale parameter
Model fit: Pearson chi-square (p)b
Log-likelihood
Between-model likelihood ratio (chi-square)
a
b
Odds
Coefficients Ratio
Model 1
Model 2
Model 3
0.20
0.06*
0.01
0.22
0.07*
0.01
0.23
0.09**
0.02
0.28*
0.10**
0.12
0.76
0.91
0.98
0.06
0.12
0.00
0.02
0.33
0.00
0.05
0.26
0.00
0.04
0.46
0.00
1.04
1.59
1.00
0.11
1.00
0.15
0.47*
0.63
0.89
0.63
0.54
2.44
0.22
0.13
1.72*
0.76**
0.51
0.57
0.84**
2.15
1.66
1.76
0.43
0.02
0.35
0.88*
1.02
1.03
1.02
1.01
127.90 (.39)
127.44 (.33) 123.43 (.35) 118.44 (.45)
81.33
77.02
73.77
71.95
8.60*
6.52*
3.63
124
121
118
117
n 130 (65 pairs of companies).

The null hypothesis is rejected if p .05. The more the p-value exceeds .05, the better the model fit (Agresti, 2002).
p .10
* p .05
** p .01
stricted model 4 had the greatest explanatory

power (Bowen & Wiersema, 2004). Thus, we used
model 4 for hypothesis testing.
Hypothesis 1a asserts that the greater the value of
a CEOs stock options, the less likely the subsequent incidence of fraudulent financial reporting,
and Hypothesis 1b counters that fraudulent financial reporting is more likely with higher values of
CEO stock options. The CEO stock options odds
ratio of 0.63 in model 4 suggests that a $1 million
increase in options decreases the likelihood of
fraudulent financial reporting by 37.2 percent. This
result supports principal-agent theory, embodied
in Hypothesis 1a, and not the unprincipled agent
view represented by Hypothesis 1b. But this overall
result must be interpreted in the context of the
effects of the higher-order interactions, discussed
next.
Hypothesis 2 states that the presence of CEO
duality increases the effect of CEO stock options on
the likelihood of fraudulent financial reporting,
and Hypothesis 3 argues that the presence of board
stock options increases the effect of CEO stock options on the likelihood of fraudulent financial reporting. The significant double interactions in
model 4, however, show that the overall salutary
effect of increasing CEO stock options is reduced in
the presence of either CEO duality or board stock
options. The significant triple interaction term in
model 4 supports Hypothesis 4, indicating the presence of an even more complex relationship,
wherein CEO stock options, CEO duality, and
board stock options jointly affect the likelihood of
fraudulent financial reporting. We diagram these
joint effects in Figure 2 (Jaccard, 2001).
Figure 2 shows the relationships between CEO
stock options, CEO duality, board stock options,
and fraudulent financial reporting. When CEO duality and board stock options both exist, the relationship between CEO stock options and the likelihood of fraudulent financial reporting is negative.
When CEO duality and board options are both absent, increases in the value of CEO options also
decrease the likelihood of fraudulent financial re-
2006
493
FIGURE 2
Interactions of CEO Stock Options by Board Stock Options by CEO Duality
porting. Thus, when CEO duality and board stock

options are either simultaneously present or simultaneously absent, increases in CEO stock options
decrease the likelihood of fraudulent financial reporting. When CEO duality exists but board options
do not, however, the relationship between the
value of CEO stock options and the likelihood of
fraudulent financial reporting is positive. Similarly, when duality is absent but board options are
present, the relationship between CEO stock options and the likelihood of fraudulent financial reporting is also positive, with the greatest effect at
higher levels of CEO options. Thus, when either
CEO duality or board stock options is present while
the other is absent, increases in CEO stock options
increase the likelihood of fraudulent financial
reporting.
Together, these findings support the moderating
effects of CEO duality (Hypothesis 2) and board
stock options (Hypothesis 3) and the joint effects of
these variables (Hypothesis 4) on the relationship
between the value of CEO stock options and the
likelihood of fraudulent financial reporting. The
effects we found, however, are more complex than
those we initially hypothesized, and findings did
not entirely support our hypotheses, as we discuss
below.
DISCUSSION
Our findings both support and extend those of
previous research. Two of our statistical control
variables are significantly related to the likelihood
of fraudulent financial reporting, as we expected
from previous research findings. These results confirm the important roles of boards of directors and
individual CEOs in corporate governance. First, the

average annual number of meetings of a firms audit
committee is negatively related to the likelihood of
fraudulent financial reporting, supporting the committees monitoring and deterrent functions examined by Klein (2002) and Schnatterly (2003), respectively. Second, CEO age is negatively related to
the likelihood of fraudulent financial reporting, as
we expected from previous research findings relating age to both risk aversion and less propensity
toward criminality (Child, 1974; Gottfredson & Hirschi, 1990). Furthermore, Figure 2 shows that CEO
duality also produces a greater likelihood of fraudulent financial reporting when CEO stock options
are not present. This finding is consistent with
arguments in the literature regarding the power and
autonomy associated with CEO duality (Coles &
Hesterly, 2000; Daily & Dalton, 1994; Finkelstein &
Hambrick, 1996), and it supports prior research.
We also extended previous research, by offering
competing arguments concerning the likely effects
of CEO stock option grants on fraudulent financial
reporting. One argument was based on a common
prescription of principal-agent theory (Jensen &
Meckling, 1976): that granting CEOs stock options
increases their financial interest in long-term share
performance, thereby aligning the CEOs interests
with those of shareholders and ensuring actions
that will benefit shareholders. The counterargument, which we labeled the unprincipled agent
view, is that once stock option grants become exercisable they provide an immediate financial incentive for CEOs to inflate near-term financial performance at the expense of long-term results. Thus,
according to this viewpoint, CEO stock option
grants might actually hurt shareholders, because
494
they could result in fraudulent financial reporting

and a reduction in long-term share performance.
Our results are mixed concerning the principalagent theory assertion that increased CEO stock
options can align CEO interests with those of shareholders; evidence of this alignment occurred only
in very circumscribed situations in our sample. We
found that increasing CEO stock options led to a
decreased incidence of fraudulent financial reporting, as predicted by agency theory, only when (1) a
firms CEO was also board chair and the firms
board had stock options, or when (2) the CEO was
not board chair and the board had no options.
Counter to principal-agent theory, we found that
increasing CEO stock options were associated with
a greater incidence of fraudulent financial reporting when (3) a CEO was also board chair and the
board was without stock options, and much more
fraudulent financial reporting occurred when (4)
the CEO was not board chair and the board had
stock options. These findings are not precisely
aligned with the predictions in our hypotheses,
however. We expected that two combinations
CEO duality with board options, and no duality
and no board optionswould have the largest effects, but that was not the case. Instead, with high
levels of CEO options we found, as expected, that
no CEO duality with no board options produced
the least likelihood of fraudulent financial reporting in our sample, but we also unexpectedly found
that no CEO duality with board options resulted in
the greatest likelihood. We next offer some interpretations of these findings.
Generally, our results indicate that the effects of
board stock options and CEO duality differ as the
value of options held by a CEO increases. With no
CEO stock options, CEO duality is the dominant
effect and is associated with a greater likelihood of
fraudulent financial reporting. This finding is consistent with the arguments that CEO duality indicates CEO power (e.g., Dailey & Dalton, 1994) and
that some CEOs may use such power to circumvent
corporate governance processes. As a CEO receives
more and more stock options, however, whether or
not his or her board of directors also has stock
options has an increasing influence on the likelihood of fraudulent financial reporting. Furthermore, this influence varies depending on whether
or not the CEO is also chairperson of the board.
When the CEO is not chair and the board has no
options (situation 2 above), the likelihood of fraudulent financial reporting decreases to its lowest
level for our sample as CEO options increase. In
this situation, the external chairperson and board
members maintain their monitoring function and
appear particularly vigilant as the CEOs options
June
increase, even without extra, agency-based interest alignment from stock options of their own.
When the CEO is not also the chair and board stock
options are present, however (situation 4 above),
the likelihood of fraudulent financial reporting increases greatly as CEO options increase. This pattern of findings contradicts the agency theory argument that stock options for directors increase their
vigilance and engagement (Finkelstein & Hambrick,
1996; Hambrick & Jackson, 2000) as well as the idea
that the relatively low power of a nonchair CEO
always limits opportunistic behavior on his or her
part. It may be that in such cases board stock options coopt the board (including its chairperson) by
providing incentives for members to abrogate their
internal monitoring role and turn a blind eye to
actions designed to keep short-term stock price
high. This effect may be reinforced by the likelihood that the value of board options increases with
the value of CEO options (Gomez-Mejia, 1994). Another potential explanation of our results for the
combination of nondual CEO with board stock options is that the directors may assume that the
outside chairwho is often a former CEOis doing
effective monitoring, and so they therefore decrease
their collective vigilance. This decreased vigilance
would allow the CEO greater freedom to pursue
actions that promote personal gain as the value of
CEO stock options increases.
When a firms CEO was also board chair in our
sample, on the other hand, increasing CEO options
were associated with a lesser likelihood of fraudulent financial reporting when the firms board of
directors also had options (situation 1 above). This
apparent vigilance over a powerful CEO may occur
because board stock options result in increased vigilance, as agency theorists hold (Finkelstein &
Hambrick, 1996; Hambrick & Jackson, 2000), or it
may occur because CEO duality itself spurs board
vigilance (Finkelstein & DAveni, 1994). Increasing
CEO options when a CEO was also chairperson,
however, was linked with greater likelihood of
fraudulent financial reporting if a board had no
options (situation 3 above). In this latter case, it
may be that the dual CEOs greater power to pursue
self-interest simply overwhelms the boards intentions to monitor. Such dominance by powerful
CEOs is consistent, for example, with Pollock, Fischer, and Wades (2002) similar finding that CEO
duality was associated with repricing of CEOs
stock options.
Our study has a number of limitations that must
be kept in mind when evaluating these results.
First, the relative infrequency of financial reporting
fraud kept our sample fairly small: only 103 (reduced to 65) companies from our population of
2006
approximately 9,600 U.S. public firms had been

discovered (at the time of data collection) to have
engaged in fraudulent financial reporting under the
strict selection standards we set. This number of
transgressive firms resulted in a matched-pair sample of 130 firms in total. The matched-pair design is
relatively powerful, however, and is increasingly
so as matching accuracy increases (see, for example, Sheskin [2000]; Appendix A provides our
matching procedures). Second, our sample primarily consisted of large U.S. firms, but forced financial restatement likely is a phenomenon that also
occurs in smaller firms. During the period 1998
2003, for example, the Huron Consulting Group
(2003, 2004) found that 48 49 percent of firms
restating because of fraudulent financial reporting
(excluding changes in accounting principles and
nonfinancial matters) had annual net sales of less
than $100 million. Only 7.7 percent of the 65 restating firms in our study had annual net sales of
less than $100 million. This discrepancy could be a
consequence of the greater publicity given larger
firms, which affected our likelihood of detecting
such firms restating under regulatory pressure via
news accounts; or the discrepancy could be a consequence of the greater regulatory attention that
large firms face. Thus, our findings are more generalizable to larger firms than to all U.S. companies.
Third, several of the firms for which we could not
find appropriate matches were outliers in one way
or another. Often, they were very large firms that
dominated concentrated industries (e.g., Enron).
Thus, one must be careful in generalizing our results to dominant firms in concentrated industries.
Fourth, our results may not extend to private enterprises, where there may be higher levels of monitoring than in public companies and where managers bear higher compensation risk than do their
counterparts in public corporations (Tosi & GomezMejia, 1989). Finally, we were unable to include
the degree to which the CEO options in our sample
were in the money in our analyses, because we
could not determine unambiguously when the decision was made to misreport financials. Our results suggest that the Black-Scholes option value
over a range of years is a useful measure of incentive compensation. Future research incorporating
in-the-money value may produce additional insights, however, particularly regarding option
holders behaviors as the price of a stock approaches (but hasnt yet reached) the option strike
price.
Notwithstanding these limitations, our results
have a number of important implications for researchers and practitioners. For researchers, our
findings suggest that the effects of governance
495
mechanisms on managerial behavior are more complex and more interactive than has been hypothesized. Some scholars have noted the limitations of
considering each governance mechanism independently of others and have advocated examination of
joint or substitution effects (e.g., Agarwal &
Knoeker, 1996; Rediker & Seth, 1995). Our findings
indicate that simple substitution may be too basic.
Future research instead should focus on joint effects that may reflect power relationships between
a CEO, a board of directors, and a non-CEO board
chair, and on the effectiveness of various incentives
for these parties. Clearly, many issues concerning
incentives remain to be investigated, including the
following: how stock options could be implemented more effectively; the relative effects of
stock ownership versus stock options; and the influences of CEO, nonexecutive chairperson, and
board power, and the balance of such power, on the
design and implementation of incentives. Studies
comparing the various forms of board compensation and their influence on corporate governance
are needed. Simultaneous (i.e., interactive) effects
of governance mechanisms on fraudulent financial
reporting, and curvilinear relationships, should
also be explored. For example, Latham and Jacobs
(2000) found that management stock ownership of
0 5 percent and over 25 percent was conducive to
alignment with shareholder interests, but that opportunism occurred in the 525 percent range
(where our samples 7 percent mean is located).
Thus, many corporate governance issues warrant
further research.
Nevertheless, important advice can still be provided for practitioners. A firms board plays a key
role in the firms governance through both its audit
and compensation committees. Effective monitoring by the audit committee is essential to good
corporate governance. Our results show that monitoring via frequent audit committee meetings is an
effective deterrent to fraudulent financial reporting
by managements in large firms. Development of
CEO incentives by a boards compensation committee can also be an effective deterrent, but only either when the CEO is also chairperson and the
board has stock options, or when the CEO is not
chairperson and the board doesnt have options.
With other combinations of CEO duality and board
options, increasing CEO options increases the likelihood of fraudulent financial reporting. Alternative forms of executive compensation that increase
ownership risk, such as restricted stock grants, may
yield better alignment with shareholder interests
than do CEO stock options. Also, the unfavorable
effect that board stock options sometimes appear to
have on fraudulent financial reporting raises con-
496
June
cerns about the consistency of the fiduciary role

directors serve for shareholders. This effect also
validates increases in the external monitoring of
regulators (via the Sarbanes-Oxley Act of 2002, for
instance) and heightened activism by outside institutional observers (e.g., CalPERS).4 Finally, our results indicate that CEO duality is neither universally positive nor universally negative for corporate
governance. In a firm with CEO duality, the worst
situation as regards potential fraudulent financial
reporting arises when the board of directors is without stock options and the value of CEO options is
high. Without CEO duality, the worst situation as
regards potential fraudulent financial reporting occurs when the directors have stock options and the
value of CEO options is high. Further research is
needed, however, before more specific policy recommendations can be made with full confidence.
Evidently, effective deterrence may not be as
straightforward as previously thought.
Balsam, S., Mozes, H., & Newman, H. A. 2003. Managing

pro forma stock option expense under SFAS No. 123.
Accounting Horizons, 17(1): 31 45.
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APPENDIX
Matching Procedures
The initial sample of 103 companies was reduced to 65
owing to firms failure to meet selection criteria or inability to be matched. The 38 firms removed from the sample
included 25 that failed to meet the criterion of being
independent, U.S. public firms during the full period
19962004 because of corporate turbulence in the form of
acquisitions, liquidations, and the like. Also, 13 were
eliminated because we could not find firms that matched
them on the basis of 1999 industry (four-digit SIC) code
and 199699 average annual net sales. Five of the matching covariatesindependence, U.S. citizenship, public
ownership, 19962004 time period, and industrywere
categorical. The primary data source for these five categorical matching covariates was the SECs EDGAR database, primarily SEC Form 10-K Annual Reports and DEF
14A Definitive Proxy Statements (U.S. Securities and
Exchange Commission, 2004). Brief descriptions of the
matching criteria follow.
Matching Criteria
Independent public firm in 19962004. All 130 firms
in the 65 matched pairs were independent, public firms
during the entire period 19962004, but only the first six
months of the last year, 2004, were included .
U.S. citizenship. All but 2 of the 130 firms were incorporated under U.S. law. To address the possibility that
changes in corporate citizenship by United Statesheadquartered firms truncated our sample (for instance, Tyco
International became a Bermuda corporation while retaining its headquarters in the United States), we also
examined 41 U.S. expatriate firms. Four were found to
have restated financials under pressure during the period
200004. Two of those four failed to meet the criterion of
independence and public trading throughout the focal
period, leaving two expatriates in the sample of 65
matched pairs.
Four-digit SIC. All firms except one were matched on
the basis of the four-digit SIC code found in the U.S. SEC
Forms 10-K Annual Reports filed for the fiscal year most
closely identifed with calendar year 1999 (U.S. Securities
499
and Exchange Commission, 2004). Both the 1999 and

2004 SIC codes of the exceptional firm, a conglomerate,
bore no relationship to any of its four business segments.
Thus, we matched it to another conglomerate whose
1999 and 2004 SIC codes also had no relation to its five
business segments. Instead, the match was based on the
identical four-digit codes of the two largest segments of
both firms, as well as on the closeness of their 199699
average annual net sales.
199699 average annual net sales and 1996 99 average net income. We calculated these values as simple
averages.
199699 average annual vesting period. Average annual vesting period, measured in years, was determined
each year for each firm by the vesting described for stock
option grants for its executives during that year. Where
vesting periods differed among a firms stock option
grants, we used weighted averages using numbers of
shares to compute that years average vesting for that
firm. We also computed the average of the four years
average vesting periods during 199699 for each firm.
Mean/median average annual net sales, net income, and
vesting period were, respectively, $3.98/0.97 billion,
$274/50 million, and 3.2/3.5 years. Data for 199699
average annual net sales and net income were obtained
from the COMPUSTAT North American database supplemented by SEC Forms 10-K (U.S. Securities and Exchange Commission, 2004). Average vesting periods
were computed from vesting data in SEC Forms 10-K and
DEF 14A (U.S. Securities and Exchange Commission,
2004).
Tests of Matching Effectiveness

Along with industry classification, 199699 average
annual net sales was a key matching covariate. We therefore measured the fit in the sizes of two matched firms as
the absolute value of the difference in the 199699 average annual net sales of the two firms divided by the
restating firms 1996 99 average annual net sales. Defining perfectly matched sizes for all firms as 1.00, we
obtained an average match of 0.80. To test the effectiveness of the overall matching process, and to detect the
presence of any remaining selection bias, we used the
eight matching covariates and the 65 matched pairs to
predict restatement under pressure. A conditional logistic regression model was employed, the same model used
to test this studys hypotheses. Model fit and parameter
estimate statistical insignificance, in relation to the outcome variable, would demonstrate satisfactory matching
and minimal selection bias. On a multivariate basis, the
overall model of eight matching covariates was found to
be statistically insignificant (p .10), thus demonstrating matching effectiveness and minimal selection bias in
the 65 matched pairs constituting this studys sample.
Both full and reduced matching models showed little or
no multicollinearity (variance inflation factors ranged
from 1.00 to 1.48, where 10 is the threshold for multicollinearity), and no rejection of the null hypothesis of
homoscedasticity (p .05).
500
June
Joseph P. OConnor, Jr. (joconnor@utep.edu) is an assistant professor of management at the University of Texas
at El Paso College of Business Administration. He earned
his Ph.D. in organizations and strategy at the University
of WisconsinMilwaukee. His research interests include
the strategy-making process and the relationships between organizational learning, innovation, and strategic
decision making.
research interests include the strategy-making process

and chief executive decision making.
Joseph E. Coombs (jcoombs@mays.tamu.edu) is an assistant professor of management at Texas A&M University.
He received his Ph.D. from Temple University. His research interests include geographic clustering, organization legitimacy, executive compensation, and corporate
governance.
Richard L. Priem (priem@uwm.edu) is the Robert L. and

Sally S. Manegold Professor of Management and Strategic Planning and a professor of management in the Sheldon B. Lubar School of Business at the University of
WisconsinMilwaukee. He earned his Ph.D. in strategic
management at the University of Texas at Arlington. His
K. Matthew Gilley (gilleyk@okstate.edu) is an associate

professor of management at Oklahoma State University.
He holds a Ph.D. in strategic management from the University of Texas at Arlington. His research interests include executive compensation, corporate governance,
and outsourcing.

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Academy of Management Journal

2006, Vol. 49, No. 3, 483500.

DO CEO STOCK OPTIONS PREVENT OR PROMOTE

Accurate financial reporting by listed firms is

We thank Paul Clikeman, Tim Haas, David North, Paul

Academy of Management Journal

Principal-Agent Theory and Moral Hazard

firm owners and (2) the proper role of a firms board

OConnor, Priem, Coombs, and Gilley

CEO duality occurs when a single individual serves

option compensation is also present, and that this

Academy of Management Journal

ings for the same period in a prior year adversely

OConnor, Priem, Coombs, and Gilley

associated with CEOs bonuses, and Healy (1985)

venting the governance process in an attempt to

Academy of Management Journal

tions and fraudulent financial reporting beyond the

The SEC is the U.S. Securities and Exchange

OConnor, Priem, Coombs, and Gilley

counting for stock-based compensation using the

Academy of Management Journal

remainder. The values were computed using the

To convert firm Black-Scholes data, which contained

as the chair of its board of directors at any time

OConnor, Priem, Coombs, and Gilley

to prospect theory (Kahneman & Tversky, 1979),

in which it did not. Thus, the dependent variable

Academy of Management Journal

n 130 (65 pairs of companies).

stricted model 4 had the greatest explanatory

OConnor, Priem, Coombs, and Gilley

porting. Thus, when CEO duality and board stock

individual CEOs in corporate governance. First, the

Academy of Management Journal

they could result in fraudulent financial reporting

OConnor, Priem, Coombs, and Gilley

approximately 9,600 U.S. public firms had been

Academy of Management Journal

cerns about the consistency of the fiduciary role

Balsam, S., Mozes, H., & Newman, H. A. 2003. Managing

Agarwal, A., & Knoeker, C. R. 1996. Firm performance

Barton, J. 2001. Does the use of financial derivatives

Black, F., & Scholes, M. 1973. Pricing of options and

OConnor, Priem, Coombs, and Gilley

Coles, J. W., & Hesterly, W. S. 2000. Independence of the

Daft, R. I., Sormunen, J., & Parks, D. 1988. Chief executive

Guidry, F., Leone, A. J., & Rock, S. 1999. Earnings-based

Hambrick, D. C., & Jackson, E. M. 2000. Outside directors

DeFusco, R. A., Johnson, R. R., & Zorn, T. S. 1990. The

Hayward, M. L., & Hambrick, D. C. 1997. Explaining the

Academy of Management Journal

ship structure. Journal of Financial Economics, 3:

tunity, choice, and corporate illegality. Organization Science, 8: 624 647.

Jensen, M. C., & Murphy, K. J. 1990. Performance pay and

Miller, J. S., Wiseman, R. M., & Gomez-Mejia, L. R. 2002.

Kahneman, D., & Tversky, A. 1979. Prospect theory: An

Kerr, J. L., & Kren, L. 1992. Effect of relative decision

Pollock, T. G., Fischer, H. M., & Wade, J. B. 2002. The role

Priem, R. L. 1994. Executive judgment, organizational

Rediker, K. J., & Seth, A. 1995. Boards of directors and

Knight, J. A. 2002. Performance and greed. Journal of

Sanders, W. G. 2001. Behavioral responses of CEOs to

Kochan, T. A. 2002. Addressing the crisis in confidence