Reducing CEOs” stock-option compensation can help limit risky investments

October 23rd, 2008 - 12:50 pm ICT by ANI  

Washington, Oct 23 (ANI): A new University of Missouri study has found that decreasing option-based compensation of chief executive officers (CEOs) help in reducing risky investments.

After the recent credit crunch, people have criticised firms large executive pay packages.

In fact, John White, director of the Securities and Exchange Commission’’s Division of Corporation Finance, has urged all U.S. companies to consider reduce compensation packages that reward excessive risk-taking by executives.

The new study provides evidence that decreasing stock option-based compensation of CEOs after companies” earnings restatements leads to a decrease of risky investments and improved profitability.

An earning restatement occurs when companies revise their earnings from what they previously reported, because of accounting irregularities or errors.

“While stock options can be used to persuade mangers to take risky positive projects, high levels of options can induce excessive risk-taking in investment decisions,” said David B. Farber, assistant professor of accountancy in the MU Robert J. Trulaske, Sr. College of Business.

He added: “When these investments do not produce net positive returns, managers may engage in earnings management to mask underperformance. This can ultimately result in a restatement.”

For the study, the researchers analyzed 289 firms that had earning restatements from 1997 to 2001.

It was found that in comparison to other firms, firms that restated earnings were more likely to re-contract with their CEOs after the restatement and reduce the proportion of CEOs” total compensation that was stock option-based.

Following such reduction, the firms saw a decrease in risky investments and improved operating performance, which led to a better bottom line.

“It’’s easy for the well-intended CEO who has too many stock options to take risky investments. The research results strongly support that a decrease in option-based compensation reduces CEOs” incentives to take excessively risky investments, resulting in improved profitability,” said Farber. (ANI)

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