is there a link between executive--pak gudono

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Accounting Research Center Booth School of Business University of Chicago

Is There a Link between Executive Equity Incentives and Accounting Fraud?Author(s): Merle Erickson, Michelle Hanlon and Edward L. MaydewSource: Journal of Accounting Research, Vol. 44, No. 1 (Mar., 2006), pp. 113-143Published by: on behalf ofWiley Accounting Research Center, Booth School of Business,University of ChicagoStable URL: http://www.jstor.org/stable/3542319Accessed: 22-03-2016 04:24 UTC

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DO 101111/1475679X200600194x

Journa ofAccountngReearch

V o 44No1 M arc h 2006

P rn te dn U S A

Therea LnkbetweenExecutve

Equty ncentve andAccountng

Fraud?

MERLEERCKSON* MCHELLEHANLONtAND

EDWARDL MAYDEWt

Receved8Apr 2004accepted3 Augut2005

ABSTRACT

Wecompareexecutveequtyncentve offrm accuedofaccountng

fraudbytheSecurte andExchangeComm onSEC durngtheperod

19962003w t h t wo amp e of f rm n ot a cc u e d of f rau dWe me au re e qu t y

n c en t v e n av are t y ofw ay an d e mpoy ab at t ery of e mprc a t e t We f n dn o

con tentevdencethatexecutveequty ncentve area ocatedwthfraud

Th e e re u t t and n c ont ra t t o a e rt on byp o c ymak er t hat n c e nt v e

fromtockba edcompenaton andthereut ngequtyhod ng ncreae the

ke hoodofaccountngfraud

1 ntroducton

S ome of t h e arg e t a cc oun t n gf rau d n h t ory o c cu rre dn t h e a t e v

e ray e ar e adng t o t h e w e k n ow n uph eav a n t h e a cc oun t n gn du t ry

*U n ve rt y of C h c ago t U n v e rt y of M c h g an t U n v er t y of Nort h C aron a We h ave

beneftedfromcomment fromRayBa edtor RobertBuhman aDchev ArthurKraft

M ark L an g Sh v aRag opaJoh n Robn on S t e ve Ro c k Ph Sh an e Te rry Sh e vn Joe S e mrod

w ork h opp art c p an t a t L ond on B un e S c hoo M c h g an S ta t e U n ve rt y U C B erk e ey

U CLA t h e U n v er t y of C oorad o t h e U n ve rt y of F ord a t h e Un v e rt y of North C aron a

t h e Un v e rt y of Oreg on t h e U n ve rt y of Te x a a t Au t n an dWah n gt on Un v e rt y an d

ananonymou refereeJudon Cakey ScottDyrengandBradLnd eyprovdedvauabe

reearcha tanceWeapprecatefundngfromtheUnver tyofChcagoGraduateSchooof

Bu n e t h e Ro S c hooof B u n e a t t he U n v e rt y of M c h g an and an E rn t &Y oungF ac u ty

F e ow h p an d t he U n v e rt y of Nort h C aron aKe n an F ag e rB u n e S c hoo re p e ct v e y

113

Copyrght?Unver tyofChcagoonbehafof then ttuteofProfe onaAccountng2006

http://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsp


3/32

114MERC KSON MHANLON AND EL MAYD EW

an dw e epn g e g at v e and re gu at ory c h ang e Th e e e v en t h av e e f t e g

a t or re gu at or p rac t t on er an d acad emc e arc h n gf orc au e of t he e

fraud Undertandngtheunderyngforcethatgaver etothee fraud

anece aryprecurortoeffectvey preventngfutureoccurrence Many

haveuggetedthattheexpanaton e nthe ncentve andopportunte

forperonaga nfacedbyexecutve

On e of t h e n c en t v e t h at man age rm gh t b e re p on dn g t o t h e n c re a e

ntheproportonoftherweaththat tedto tockbaedcompenaton

an d t h e re u t n g e q u tyh odn g t w e d o cumen t ed t h at th e u e of t o ck

opton a aformofexecutvecompenatonro edramatcay durngthe

1990 a d d o t h erf ormof p ay f orp erf orman c e p an u c h ag ran t of

re t rc te d t o c k andb on u p an t e d t op e rf ormanc e Murph y1999 A

ubtanta bodyoftheoretca workbegnnngw thJenenandMeckng

1976 h ow t h at th e e p an c an b e u e fu n a gn n g t he n ce n t ve of

manag er w t h t h o e of h are hod e r F oow n g t h w ork many e mpr

care earcher havepredcatedtheranay e onthepreme thatgrantng

op t on c on t en t w t h f rmv au e maxmzat on f ore x amp e e e D em

e t zandL e hn 1985 Hmme b ergH ubbard an dP a a 1999 C ore an d

Gu ay 1999 an dRagop a an d She vn 2002 M ore ove ra n umberof

e mprc ap ap er f n d re u t c on t en t w t h t he n c e n t ve a gn me nt v e w

F ore xamp e B rc k e yB h agat an dL e a e 1985re p ort p o t v e t o c k p rc e

reacton toannouncement ofong termmanagera compenatonp an

An ot h ere x amp e L e we e n L ode rer an dRoe nf e d 1985 w h of n d e v

d e nc e c on t e nt w t h man ag e rb e n g e k e y t omake me rg e rbd t h at

ow ert h e r t o ck p rc e w he n t he yh odmore t o ck n t h e f rmc on t e nt

w t h t h e rn t ere t b e n g agn e dw t h h areh od er Th ere e v en ome

emprca evdencethat onaverage executve tockoptonare effectve

ngeneratngpo tvefuturepayoff forthefrm nterm ofaccountng

e arn n g H an on Rag opa an d She vn 2003

Howeverthereareother thatvewoptoncompenatondfferenty

Somearguethatoptonare anneffcentwaytocompenatemanager

(Jenter [2001], Meulbroek [2001], and Hall and Murphy [2002]), that

manager ue optongrantforther ownbeneft AboodyandKa znk

2000Y e rmac k 1997 ort h at t o ck op t on d on o t e xh b t e mpr

c are a t on c on t e nt w t h t h e e con omc mot v at on b e h n dgran t ng

themYermack 1995 Further recentworkbyBebchukFr edand

Waker2002 arguethatexecutve havethepowerto nfuencetherown

paythatexecutveu ethatpowertoextractrent andthattherde re

tocamoufagether rentextractonmght eadtotheue ofneffcent

payarrangement thatprovdeuboptma ncentve therebyreducng

1 n add t on n a t u dy of n e w e con omyf rm t t ne rL arc ke ran dL ambe rt 2003f n d t h at

owerthanexpected tockoptongrantand/orext ngoptonhod ng area ocatedwth

oweraccountngandtockprce performancen ubequentyear Howevertheyfnd tte

con tenta ocatonbetweenfutureperformanceandgreaterthanexpectedoptongrant

andhodng



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EXECUTVEEQUTY NCENTVESANDACCOUNTNGFRAUD115

h are h ode rv au e n re a t edw ork B arG an dB eb c huk 2003an d

GodmanandSezak 2006mode managera ncentve toreporttruth

fu yand howthatperformancebaedcompenatoncan nducemanager

tom reportperformanceJenen2003 a ertthatnon neartyn payfor

p e rf ormanc e y t e m n duc e man age rt o e an d t hat u c h y n g op e rva

vethatfrm woudbebetteroffadoptngo ey nearpayforperformance

ytem

Gventhencreaedu eofperformancebaed compenaton overtme

and t h e t he ore t c a an d e mprc a argumen t of t h ort c omn g t p o

bethatthepercevedncreae ncorporatefraudn theate1990 andeary

2000 wa apredctabeoutcomeoftheechanged ncentve ndeed th

concuon eemto havebecomeacceptedw domamongpocymaker

andreguator ForexampeA anGreenpanCharmanoftheFederaRe

e rve B o ard n h e mann u amone t aryp o c y re p ort t oC on gre on Juy

162002 p e cu a t ed ab out t h e c au e of t he a c cou nt n gf rau d a f o ow

An n f e ct ou g ree d e e med t og rpmu c h of ourbu n e c ommun ty

Toomanycorporateexecutve oughtway to harvet omeofthoe

to c k mark et g an A are u t t h e h gh yd e rab e p read of h are hod

ngandopton amongbune manager perverey createdncentve

t o art f c ay n f ate re p ort ed e arn ng n ord ert ok e ep t o ck p rc e h gh

an d r n gTh ou tc ome u gge t t h at t h e opt on w ere p oory t ruc t ure d

an d c on e qu e nt y t h ey f ae d t op rop ery a gn t he on g t e rmn t ere t of

harehoder andmanager theparadgmo e enta foreffectvecorpo

rategovernance Thencentvetheycreatedovercamethegood udgment

oftoomanycorporatemanager t notthathuman havebecomeany

more g re edy t han n g e n e ra t on n t h e p at t t hat t h e av e nu e t o e x p re

greedhadgrowno enormou y

Furtherevdence found nproecutor argument nthee fnanca

accountngfraudcae Forexampe ntheBerneEbberca e theformer

CEOofWordCom theproecutonarguedthatEbberwa motvatedto

commtfraudwhentheendofawaveofmerger andthebegnnngof

ametdownn theteecomndutryputpre ureonthecompany hare

p rc e Th e y argu ed t h at E b be r p e rona f ort une w a arge yb ae d on

WordComh are an dh e had b orrowe dn eary $ 400m on w t h t ho e

h are a c o a t e ra A c kman 2005 E bbe rman t an e d t hat h e c ommt

tedthefraudtokeepupwthWa Streetexpectaton andnotforperona

g an h e h e dh h are unt WordComf e d f orb an kru pt c yn Juy2002

threemonth afterhewa forcedtore gnandonemonthafterthefraud

w aun c ove redA c k man 2005 Sm ara e g at on ab ou t t he n k b et w ee n

f rau d an d e xe c ut v e t o c k op t on w ere made n o t he rc a e e g H e a th

ou th Th e purp o e of t h p ape r t o e x amn e w h et h ert h e e mprc a e v

d e nc e u pp ort t he c am t h at e q u t yn c en t v e re u t n gf romt o c k b ae d

compenaton arepo tvey a ocatedwththeprobab tyofaccountng

fraud

We b egn by d e nt f yn g a f rm e xp c t y ac c u e d of a cc oun t n gf rau d

bytheSecurte andExchangeComm onSEC durngtheperod



5/32

116MERC KSON MHANLON AND EL MAY D EW

January 1996 to November 2003. Using actual SE C allegations of fraud

v od b ae t h at c an o cc u rw he n a amp e e e c te d b a e d on re e arc h er

nterpretaton aboutwhchaccountngprobem arethereut offraudand

w h c h are n o t Af te rome re t rc t on n c u dn g th e av a ab t y of e xe c ut v e

c omp e n at on d at aou ramp e c on t of 50f rm ac cu e d of a c count n g

fraudbytheSECdurngth perod hereafter the fraudfrm or fraud

amp e We c omp are t h e f rau d f rmw t h t w o amp e of f rm n ot a cc u e d

of f rau dF r t w e c omp are t he f raud f rm w t h amat ch e d amp e of f rm

hereafter the matched ampe nwhchwe eecttwomatchedfrm

n ot a cc u e d of f rau db ae d on ze y e aran dn du t ry f ore a ch f raud f rm

Second wecomparethefraudfrm wthanunmatched ampeoff rm

c on t n g of a re man n gf rmye ar me an n g a f rmye aro t h ert h an

thoeof the50fraudfrm onExecuComphereafterthe unmatched

ampe

Weet mateavaretyofequty ncentvemeaure forthetopfveexecu

t v e a t e a c h f rmf oc un g p e c f c ay on t h e e xp e ct e d c han ge n v au e of

theexecutve tockandoptonportfo otoa 1% tockprcechange here

after en tvty n unvarateandmutvarateana ye forthematched

amp e w e f n dn o gn f c ant a o c a t on b et w ee n f rau d an d th e e n t v

t y of e qu t yh odn g n t h e unmatc h ed amp e u n g og t c re g re on

w e f n d gn f c ant a o c a t on b e t we e n fraud an d e n t v t yw h en w e

n c u d e n o c on t ro v arab e n t h e reg re on H ow ev e rt h e e a o c a

ton become n gnfcantwhenwencudecontro forcorporategover

nance thedere forexternaf nancngfnanca performance andfrm

ze

naddtona anaye weexamnewhetherthere evdencethatexecu

t v e a t f rmac c u e d of f rau dy t e mat c ay e t o ck an d e xe rc e op t on

durngtheperodofthea egedfraudtoa greaterextentthanexecutve

nthematchedandunmatched ampe ofcontro frm Wedonotfnd

gn f c ant ygre a te rt o c k a e orop t on ex e rc e by e x ec u t ve a t f rau d

frm comparedtononfraudfrm regarde ofwhetherthecomparon

baedon thematchedampe ortheunmatchedampe

S ome c ave a t are n orde rWh e ou ramp e of f raud f rm b ae d on SEC

a e g at on of f rau d an d t he ref ore f re e of re e arch erc a f c a t on b a

there noperfectmethodof dentfyngfrm thatengagen accountng

f rau dWh at ourt e t re y on t hat t h e probab t y t hat af rme n g ag e dn

f rau d g rea t erf orf rm ac cu e d of f rau dby t he S E C t han t f orf rmn ot

accuedbytheSEC

Ne ve rth e e an y c a f c a t on of f rm n tof raud an dn onf rau d c a te

g ore w n e v taby c ont an b o th Typ e an dTyp e e rror f w e a ume

th at th e Type e rror re a t v e yma n f rm ac cu e d of f raudby t h e S EC

re a t ve t o o t he ramp e e e c t on me t hod e g ze of d c ret on ary ac

c rua t h en ou rt e t are b e t n t e rp ret e d a on t t e t of t he k e h ood

of e ng agn gn f raud an db e n g c au ght by t h e S EC t un k e y h owe v er

thattheSECcatchea fraudandthu theampe contan anunknown



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amount of Typ e e rror2Wh e n an d e a w ordw e w ou dh av e ap e rf e ct

amp e w e mpy c ann o t re abyd e n t f y f rmt h at c ommt f rau d an dg et

awaywth t Oneapectofthepotentaundercountngoffraud thatt

coud nducea eemnga ocatonbetweencompenatonandfraudeven

f n one e x t ed Th c ou d o cc u rf t h e S E C more k e y t on v e t g a t e

o rn v e t g a t e w t h more c ru t ny ac count n gp rob e m t h at o c cu rn f rm

t hat p ayh gh e v e of t o c k b ae d c omp e n at on t o t h e re xe c ut v e n t h at

c a e t he S E C ow n e e c t on c rt era c ou d n duc e an a o c a t on b et w ee n

compenatonandSEC nvetgaton and/ora egatonof fraud

Th e p ap e rp ro c ee d a f o ow n e c t on 2w e d c u p rorre a t ed t er

a t ure n e c t on 3w e d c u t h e amp e e e c t on S e c t on 4c ont an t h e

re u t an d e c t on 5c onc u d e

2 ProrRe earchontheDetermnantofFraudandReated ue

Wh e t h e e t of p ap e rt h at ex amn e ac c oun t ngf raud ma n n umbe r

thebroadercontextofth tudyreateto compenatonandf nancare

p ort n gn c e nt v e F ore xamp e Ke d a 2003 C h en g an dWarf e d 2005

Ke 2002 andGaoandShreve 2002examnethereat onbetween

compenatonandearnng managementmeaure eg d cretonaryac

c rua e arn n g t h at u t me e t orb ea t an ay t f ore c a t ma p o t v e e arn

n g an n oun c eme nt e t c Rc h ard on Tun aan dWu2003an dE f en d

Srvatav andSwanon2004 examnethereatonbetweencompenaton

an d re t at eme nt an dD en H anouna an d S arn 2005 e x amn e t h e re

a t on b et w ee n c omp en at on an d c a a c t on aw u t Ou rt u dyfo c u e

on f rmac c u e d of n t en t ona y f rau du e n t ym t at ng e arn ng Wh e

earnngmanagementre tatement andfraudharecertantrat andare

a phenomenaworthyof tudytheyarenotthe ameFraudandearnng

managementdffer nthatearnng managementcanbew thnorout de

ofgenera yacceptedaccountngprncp e GAAP wherea a egedfraud

u e nt a c c ou n t ng n v araby ou t d e of GAAPn add t on ac c ru a mode

areuefu npartbecauetheycanbeapp edtotheentremarketbutare

u b e ct t ow e k now n m t at on e e D ec h ow S o an an d Swe en e y 1995

Gu ay Koth ar an dWat t 1996 an dH eay an dWah e n 1999 F rau d an d

re t a te men t d f f e rn t h at re t a te men t d on o t n e ce ary re f ec t ap rorn

tenttodecevewhereafraudbydefnt onnvove ntenttodeceve For

exampePa mroeandSchoz 2002examne492re tatementandf nd

thatony11%reu t nanAccountngandAudtngEnforcementReea e

AAER u e d agan t t h e f rman d on y 38% re u t n t g at on Th

con tentwthretatement refectngawde varetyofbehavorrangng

fromgenunedagreement overtheappcatonofGAAPto pecfc et

2 Although one could argue that very large magnitude frauds are more difficult for managers

t oh d e n d e f n t e y an d t h u t h ere w ou db e e m c a f c a t on of fraud n v ovn g arg e

magntude



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oftranacton conttutngfraudExamnng thepurportedcaue off

n anc a a c cou nt n gf rau d mport an t n t ow n rght a e v d en c ed by t h e

wdepread mpactofthefnancaaccountngfraudofrecentyear The

re man de rof ou rd c u on of t he t e ra t ure p e c f c ay f o c u e d on pap er

reatedtoaccountngfraud

We are aware of on y t wopu b h e dp ap e rt h at ex amne p o b e n k

betweenequtyncentveand fraudDechow Soan andSweeney1996

examnethecaue andconequence offrm ubecttoSECenforcement

ac t on du rng t h e y ear19821992Th ey f n d t h at f rm ub e ct t o e n

forcementactonaremore keytohaveboard ofdrectordomnated

bymanag eme nt aC EOw ho a oC h arman of t he B o ard aC EOw ho

a o t h e f rm f oun d er n o au d t c ommt te e an dn oou t d e b o c k hod e r

Wh e n o t t h e f oc u of t h e r t u dy D e ch ow S o an an d Sw ee ne y 1996 f n d

n o gn f c ant e v d e nc e t hat amp e f rm h ad e arn n gb ae d b on u p an

ort h at of f c er an dd rec t or made un u u a amoun t of t o ck ae d u rng

themanpuatonperod Sncetheendofthe ampeofDechowSoan

andSweeney1996 n1992 tockbaedcompenatonha cometodwarf

e arn n g b ae d b onu e a af ormof n c en t v e c omp en at on We e x t en d

theworkofDechowS oanandSweeney 1996by examnngtheeffect of

t o ck b ae d n c en t v e e g t he e n t v t y of t o c k opt on an d t o ck h e d

onthepropen tyofexecutveto engagen a egedfraud

B e ne h 1999 f n d t h at manag er of f rm ub e ct t oAAER are more

k e y t o e t h e rown t o ck du rn gp erod n w h c h t he e arn ng man

ag eme nt t ak ngp ac e t h an are manag er of c ont rof rm n c ont ra t t o

D ec h ow S o an an d Sw ee n ey 1996 B e ne h 1999 d o e n o t f n d e vd en c e

thatmanageraremotvatedto nfateearnng nadvanceofanequty

uancebythef rm3

Recenty anumberofworkngpaperanayz ngaccountngfraudand

executvecompenatonhaveappearedJohnon RyanandT an 2005

fndthatexecutve offrm accuedoffraudhavegreaterunretrctedtock

ncentve to ncreae tockprcethandoexecutve offrm notaccued

of f rau dH ow ev e ra t t h e ame t me an d c on t e nt w t h ou rre u t t h ey

reportthatthefraudfrm donothavegreater ncentve fromveted tock

op t on un v e t e d t o ck op t on orre t rc t ed t o ck 4P e n g andRoe 2003

3Anot he rt u dyB e a e y 1996 f n d t hat ou t d e d re c to rd e c rea e t h e p rob ab t y of

f rau d a d oh gh ert e nu re and ow ne rh pby ou t d e d re ct o r B e a e y 1996f n d t h at t he

preenceofanaudtcommtteeha noeffectontheprobab tyoffraudbutdoe notexamne

executvecompenaton

4Thereareanumberof ampeandde gndfference betweenourpaperandthatof

Joh n on Ry an an dTan 2005 n ad d t on f w e rank ou re qu t yn c e nt v e v arab e n e t he r

ofourtestvarabes sconsstentysgnf cantn boththematchedandunmatchedsampe

H owe v er t he ran k of un re t rc te d t o c k gn f c ant y a o c a te dw t h t he k e h ood of fraud

wth ap-vaueof0 06 nthematchedsampeandap-vaueof 002 ntheunmatchedsampe

con t e nt w t h t h e Joh n on Ry an an dTan 2005me d an re u t f ort h v arab e Th e un

rank e dv aue are n gn f c ant y re a t e d to t h e k e h ood of fraud h owe v er w t h pv au e of

0797and0 230n thematchedandunmatchedampe repectvey



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fndthat ncentvepay ntheformofopton butnotretrcted tockor

b a e p ay n c re a e t he p robab t y of p rv at e e c u rt e t g a t on 5Wh e w e

cana ofnd areat onbetweenequtyncentve anda egedfraudunder

c ert an p e c f c a t on w e f n d t hat t h e re u t are n o t robu t t o a t e rn at ve

p e c f ca t on an dn c u on of c on t ro v arab e Th u w e c on c u de t h at

there nocon tentevdenceofa nkbetweenexecutveequty ncentve

andaccountng fraud

3S amp e S e e c t on an dD e c rp t on

To dentfyfrm accuedofaccountngfraudwe earchedSECAAER

fortheword fraud durngtheyear 19962003AAER are ummare

oftheSEC accountngbaed enforcementacton anddecrbetheSEC

n v e t g a t on of a e g ed v o a t on of ac count n gp rov on of t h e e c u rt e

aw We req u re AAERt o c on t an ae g a t on of f raud t ob e n c u d e dn

ou ramp e b e cau e AAERof t en n v ov e n onf rau du en t u e F e ro zP ark

an dP at en a1991 6

Tab e 1 ummarze ou r amp e e e c t on p roc ed u re F romt h e e t of

AAERdurng theperodJanuary1 1996toNovember19 2003we den

t f y 287n t an c e e x c u dn gre pe a t a cc u a t on n w h c h t he S E C u e t h e

word fraud WeexcudeAAERthatarenotreevanttothe ubectofth

n qu ry u c h a a e g ed f raudbybroke ran dd e a e r g ove rnme nt p e ron

n e orc h art ab e organ za t on We a ore q u re u f f c e nt d c ou re ab out

executvecompenaton tocomputeoure tmate ofexecutveweath en

tvtyto tockprcechange Wefr t ooktotheS&PExecuCompdatabae

ExecuComp Forthefrm wthoutExecuCompdata wheneverpo be

wehandcoectthenece arydatafromproxytatement f edwththeSEC

Th re u t n a amp e of 50f rmt h at are b ot h ac cu e d of f raudby t h e

SECandforwhch wehavecompenatondata

Tab e 1a op re e n t n f ormat on on t he t w oc omp ar on amp e u e d

n t h t u dyF rt w e c omp e a matc he d amp e of f rm n ot a cc u e d of

accountngfraudForeachofthe50f rm accuedofaccountngfraud

we eecttwomatchedfrm notaccuedofaccountngfraudmatchng

on n du t ry t w odg t S t and ard n du t raC a f c a t on SC c ode y e ar

an d f rm ze t o t a a e t Th u w e h av e 100mat c he d amp e f rm f or

t h e mat ch e d amp e t e t S e con dw e a o c ompare t he 50f rm ac cu e d

offraudwtha theremanngfrm yearon ExecuCompAfterempoyng

datarequrement creen theunmatched ampecontan 13033f rmyear

obervaton notncudng the50fraudfrmob ervaton

5 nrecenttheoretcawork GodmanandSezak 2006deveopan agencymode nwhch

tockbaedcompenaton adoubeedged word nducngmanager toexertproductve

effortbuta o nducngmanager todvertvauabe reourceto m repreentperformance

Sm ary B arG an dB eb c huk 2003mod e man ag e ra n ce n t ve t o c ommt f raud

6 For more detail on AAERs and the SEC s process in investigating firms, see Pincus, Holder,

an dM oc k 1988 F e ro zP ark an dP at e na 1991 an dD ec h ow S o an an d Sw ee ne y 1996



9/32


TABLE1

Decrpton ofSampeSeectonProcedure

Sampeoffrm accuedoffraud

TotaAccountngandAudt ngEnforcementReeae AAER uedfrom287

January1 1996throughNovember19 2003attrbutabeto a egedaccountng

fraud nondupcate

Le

F rau d ae g a t on n o t ag an t af rm ort e x ec u t ve e g a e g at on 57

n v ovn gb rok erd e a e r n v e t me nt ad v or au d t or c t yg ove rnme nt

peronne chartabeorganzaton

AAERsunreatedtofrauduentfnanca statements 1

AAERs that do not specfy the year of the a eged fraud 1

AAERf rm f orwh c h d ata are n o t ava ab e n o t on C ompu t a t o r178

E x ec u Compn op roxy t a te men t are av a ab e m n gv arab e orf rau d

predate 1992when ExecuCompcoveragebegn

Sampeoff rm accuedoffraudbytheSEC50

Sampe offrm yearnotaccuedof fraud

AMatched ampeoffrm

F rm matc h edb ae d on t w odg t n du t ry c od e y e ar an d to t a a e t 100

BUnmatched ampe

Totafrm yearava abeonExecuCompthrough200117427

Le

F rmye ar of f rm ac cu e d of f raud 191

F rmye arw t h m n gre qu re d E xe cuC ompc omp e n at on or t o ck 685

h odn gv arab e

F rmye arw t h m n gre qu re dC ompu t at f n an c a t a te men t d ata 3518

Sampeoff rmyear notaccuedoffraudbytheSEC13033

We re qu re n onm n gop t on d at a t ob e n c u de dn t h e amp e Th e c a te g ory F rmye ar

w t h m n gre qu re dC ompu t at f n an c a t a te men t d ata n c u de f rmye ar n t h e f n an c a

ervce ndutryforwhchourmeaure ofexantefnancngcannotbeobtaned

Tab e 2p re e n t t h e n ame of e ac h of t he 50 amp e f rmac c u e d of f rau d

by t he S E C A t he t n d c at e t h e amp e c apt ure t h e w e pu b c ze d

a e g e d ac count n gf rau d of re c e nt y e ara w e a ome t hat w ere e

p u b c ze d

ntabe3 webreakdownthenumberoffraudandnonfraudfrm forthe

un mat ch ed amp e byn du t ryp ane A an dbyye arp ane B Tomake

p ane A of manag eab e ze w e b re ak ou t on y t ho e t w odg t SC c od e f or

w h c h w e hav e one ormore f rmac c u e d of f rau dM ot t w odg t S C c od e

havenofrm accuedoffraudbytheSECdurngthetme perod nth

tudyandweumptho etogether ntoan a other category

Th e f rt ob e rv at on on e c an mak e reg ardn gp ane A t h at t h e n c

denceoffrauddoe noteemto behghy concentratedna fewndutre

The50frm accuedoffraudare preadover21 dfferenttwodg tSC

code Thendutryw ththearget aboutenumberofa egedfraud

bu n e e rv c e S C 7 3 w h ch h a 1 0 f r m a c c u ed o f f ra ud B u n e e r

v c e f rm are ove rt w c e a k e y a t h e av e rag e f rmt ob e a cc u e d of f rau d

accountngfor8 52%ofthenonfraudfrm and20%ofthea egedfraud



10/32


TABLE2

L tofFrm AccuedofAccountngFraudbytheSEC

T me P erod of

NumberCompanyNameAegedFraud

1AdephaCommuncaton Corporaton19992001

2AdvancedTechnca Product nc19981999

3 An c om n c 19982000

4A re m of t n c 20002001

5Ah f ord comn c 20002001

6Atch onCat ngCorporaton19972000

7B au c h &L ombn c 19931994

8C rt c a P a th n c 20002001

9CyberguardCorporaton19971998

10Cy nkCorporaton1998

11D agn o t ek n c 19921993

12Dynegync 20012002

13EnronCorporaton19972001

14JoAn n S t ore n c 1992

15F neHot Corporaton19961997

16Gatewaync 2000

1 7 G u f o rd M n c 1 9 97 1 9 98

18H B O&C o19971999

19 HeathouthCorporaton19992002

2 0 G n c 1 99 5 1 99 7

21 n du n t ern at on a n c 1999

22 nternatonaThoroughbredBreeder1997

23K MartCorporaton2001

24SafetyKeenCorporaton19982000

25L e ga t o Sy t em n c 19992000

26Matera ScenceCorporaton19961998

27Max nternetCommuncaton nc2000

28Mcro Warehoue nc19941996

29Mcro trategy nc19982000

30Oak n du t re n c 19951996

31Phy canComputerNetworknc1996 1997

32P re me rL ae rSy t em n c 1998

33Qwet Communcaton nternatona nc20002001

34R teAd Corporaton19982000

35 S af TL ok n c 19971998

36S gnaTechnoogyCorporaton19961998

37 StructuraDynamc ReearchCorporaton19921994

38SunbeamCorporaton19971998

39S unr e M e d c an c 19941995

40Sw h e rn t e rnat ona n c 1996

41SymboTe c hn oog e n c 19982002

42Sy t e mSof tw are A oc n c 19941996

43 TexonCorporaton1999

44Thoma &BettCorporaton19981999

45Th or n du t re n c 19961998

46Tyconternatona LTD19972002

47WRGrac e &C o19921995

48WateManagementnc 19921997

49Wordcom nc19992002

50XeroxCorporaton19972000



11/32


TABLE3

SampeofF rm AccuedofAccountngFraudbytheSECandF rm NotAccuedUnmatchedSampe

byndutryandbyYear

P ane A B yn du t ry

12

NoA egatonA egedFraud

of F rau dF rm Frm

Twod gtPercentofPercentof

SCcode ndutryNameTotaTota

22TEXTLEMLLPRODUCTS1 03%200%

23APPAREL&OTHERFNSHEDPDS103% 200%

28CHEMCALS&ALLEDPRODS835% 600%

33PRMARYMETAL NDUSTRES3 00%200%

34FABRMETALEXMACH TRANSEQ173%600%

35NDL COMMLMACHYCOMPUTEREQ7 17%1200%

36ELECTROTHELECEQ EXCMP836%4 00%

7 TRANSPORTATONEQUPMENT294%2 00%

38MEASNSTR PHOTOGDSWATCHES483%6 00%

48COMMUNCATONS206% 600%

49ELECTRCGAS SANTARYSERV824%400%

50DURABLEGOODSWHOLESALE253%200%

51NONDURABLEGOODSWHOLESALE141%4 00%

53GENERALMERCHANDSESTORES155%200%

58EATNGANDDRNK NGPLACES202%200%

59M SCELLANEOUSRETAL1 89%1000%

67HOLDNGOTHER NVESTOFFCES041%200%

73BUSNESSSERVCES852%2000%

79AMUSEMENT&RECREATONSVCS0 84%200%

80HEALTHSERVCES1 90%200%

99NONCLASSFABLEESTABLSHMNT032%2 00%

OTHER NDUSTRES2987%0 00%

10000%10000%

P an e B B yy ear

NoA e g at on of F rau dF rmA e g ed F raudF rm

34

YearPercentofTotaPercentofTota

199274% 100%

199394% 20%

199497% 60%

199599% 40%

1996108% 120%

1997114% 200%

1998114% 180%

1999108% 120%

2000101%12 0%

200191% 40%

1000%1000%

Frm arecategorzeda thoeaccuedof accountngfraudandthoenotaccued ncoumn 1

wereportthefrm notaccuedoffraudby ndutrya apercentageofa frm notaccuedoffraud

ncoumn 2 wereportthepercentageofa frm accuedoffraudn theampe thataredrawn

f romt h e re p ec t v e n du t ryn c oumn 3 w e rep ort t h e f rmye ar n w h c h t he re n o ac cu a t on

of f rau d a ap e rce n tag e of a f rmye arn o t a c cu e d of f raudun matc h ed amp e n c oumn 4 w e

reportthepercentageofa frm accuedoffraudn theampe bytheyearn whchthea egedfraud

began



12/32


M c e an e ou re ta SC 59 a o ov e rre pre e n te dn t h e a e g ed

f rau d amp e f rm n t h n du t ry are ab ou t f v e t me more k e y

thantheaveragefrmtobeaccued offraudaccountngfor189%

ofthenonfraudampe and10%ofthefraudampe Otheroverrep

re e n te dn du t re n t h e f rau d amp e n c u de c ommun c at on SC

48an d f ab rca t edme ta SC 34 Ov era h owe v er t h e da t an t h

t ab e u gg e t t h at a c c ou n t ngf raud n o t o a t ed n an yp art c u ar

ndutry

e e x c u d ed b an k an d avn g an d o an f romour amp e b ec au e an m

portantcontrovar abetheproxyforthede reforexterna fnancng

a n o t ava ab e on C ompu t a t fort h e e f rm H owe v er t h re t rc t on

onyexcudedthreefrm uggetngthatun kethea egedaccountng

f rau d of t h e a t e 1980 e e E rc k on M ayh e w an dF e x 2000 t he

a egedfraud ofthe1990 andeary2000 donotappeartobeconcen

t ra te dn b an k an d avn g an d o an

PaneBof tabe3 preentthebreakdownofSECfrauda egatonby

yearwhereyearrepreentthefr tyearthea egedfraudtookpace not

t he y e arn w h c h t h e S EC mad e th e a e g a t on Th e a e g ed f raud b e gn

a e ary a 1992an d a a t e a2001Th e n umbe rof fraud b e gnn n gn a

gv e n y earrang e f roma ow of one n 1993t o ah gh of 10 n 1997Ov era

there nod cernabetrendovertmeandthea egedfraud arenotovery

cutered nanyg venyear

Foreachofthefraudfrm weco ectthemethodofearnng overtate

me nt a d o cumen t ed by t h e S EC w h e n t h eory t he S E C c ou d u e an

AAERforundertatngearnng a oftheAAERthatweob ervedwere

f orove rt a t ng e arn ng n un tab u ate d t a t t c w e f n d t hat 56% of

thefrm wereaccuedof overtatngtherrevenue SpecfcSECaccua

ton ncudereportng fa erevenue mproperyrecognzng revenue

channe tuffng prematureyrecognzng revenue nfatng revenue

recordng revenue from the sae pror to shpment and recognzng

revenueon nva dornonex tenta e The econdmo tcommonaccu

a t on c on t of v arou t yp e of c o t ore x p en e un d ert a t eme nt ap pyn g

to34%ofthefrm Exampeof uchexpene undertatementaccuaton

c ont an edn SEC AAER n c u de c rea t ed f c t t ou a e t ov ert a t n g

nventory mproperycapta zngexpene mpropercapta zatonof

m on of d o arof c omp an y e x pe n e an d n c udn gf ake t em n n

ventory Othermore pecfc ourceofovertatement ncudepurchae ac

countngormergerreatedaccountngentre eg cooke arreerve

bartertranacton eaeaccountngmanpuaton andovertatementof

nventory

Wea oexamnethe eveofmanagementaccued ntheAAER nunt

ab u ate d re u t w e f n d t hat t he h gh e t e v e of man age men t are mot

oftenaccuedof nvovementn theaccountngfraudn morethan50%of

the cases, the CEO or the CFO was accused of perpetrating the accounting

fraudthatedtotheAAER



13/32


4 Tet oftheReatonbetweenExecutveEquty ncentve and

AegedAccountngFraudandE tmate ofManagera Beneft

fromAccountng Fraud

41 MEASUREMENTOFEXECUTVEEQUTY NCENTVEVARABLES

nth ectonwe ntroducevarabe thatmeauretheexpectedbeneft

theexecutvecoudobtan fromartfca y nfatngthe tockprceofthe

f rmt h rou gh f raudu e nt a c t on F ort he f rm ac cu e d of f rau d a v arab e

aremeauredn theyearmmedateyprecedngthefr ta egedfraudyear

H owe v er f orome f rm t h e fraudy e ar t art e d p rort o 1992an d t h u

d ataon E x e cuC omp are n ot av a ab e f ort h e e f rmye ar n t h o e c a e

andwherethefraud tartednomorethantwoyear earer we ubttutethe

year1992fortheyearprortofraud nordertokeepthefrm nthe ampe

A equtyncentvevarabe areaggregatedovertheentremanagement

te am t e dn t h e p roxy t a t eme nt f ort he f c ay e arG e ne ray t h t h e f v e

mot h gh y c ompe n at ed e x ec u t ve Th e varab e are d ef n e d af o ow

SENSTVTY= thechangen vaueofthetopf vemanager

tockretr ctedtockand tockoptonportfo o

n re p on e t o a1% c h ang e n t h e t o ck p rc e

We d c u t h me au re f u rt h erb e ow

VESTEDSTOCK AND

OPTONSENSTV TY=thechangen vaueofthetopf vemanager

portfo oofexerc abe tockoptonandunre

t rc te d t o c k n re p on e t o a 1% c han ge n t h e

t oc k p rc e We d c u t h me au re f u rth e r

beow

WedefneSENSTV TYa theexpectedchangen thetopfveexecutve

f rmb ae d e q u t yw eat h f roma1% c h ang e n t o ck p rc e Th c han ge n

w e ath c on t of t h e umof t h e ch ang e n t h e v au e of t he e x ec u t ve e m

poy ee t o ck op t on p ort foo re t rc te d t o c k h odn g an d t o c k hodn g

Weaggregateacro thethreetoderve atota doar meaureofthe en

tvtyfor eachexecutveWeaggregateacro thefrm topfveexecutve

togetatota doar meaureforthetopmanagementteamofthef rmWe

a o e x amne t h e re a t on of t h e v e t ed p ort on of t h p ort f oo t ob e n g

accuedoffraudbecauethee hodng arethoethemanagercanm

medateybeneftfromandthumayprovde greater ncentve tocommt

fraud

Theexpectedweathchange fromtockandre trctedtockaree t

matedbymu tpy ngthemarketvaue ofthetockhod ng atyearend

theyearprortothea egedaccountngfraudfortheaegedfraudfrm

by 1% For stock options, we use the method of calculating their sensitiv-

t y t o t o c k p rc e ad e c rb e d byC ore an dGuay 2002 A t h ou gh de t a

u c h at h e n umbe rof op t on e x erc e p rc e an d t me t omatu rt y are

avaabe fromExecuComporthecurrentyearproxytatementforcurrent



14/32


yeargrant muchoftheedataareunavaab e nthecurrentyearproxy

tatementforpror grant Theoneyearapproxmatonmethoddecrbed

n C ore andGu ay 19992002re q u re n format on on yf romt h e mot

recentproxytatementtoe tmatetheen tvty oftheoptonportfooto

a c h ang e n t o ck p rc e Th e e n t v t y t o t o ck p rc e f ore ac h op t on h e d

etmateda

a o pt o nv a ue / a p r c e * p r c e * 0 0 1 = e d TN Z * p r ce * 0 0 1

where

d= natura ogarthmofexpecteddvdendye doverthe feofthe

opton

T=t me t omatu rt y of t he op t on n y e ar

N= cumuatvenormaprobab tyfunctonand

Z = n S / X + T r d + a 2 /2 / a T 1 /2 w h er e S t he p r c e of t he u n

de ryn g t o c k X t he e x erc e p rc e of t he op t on r t he n at ura

og art h mof t he r k f re e n t ere t ra t e an d a t he e x p ec t ed t o ck

re tu rn v o a t t y ov e rt he f e of t he op t on 7

42CONTROLVARABLES

We n c u d e av are ty of c ont rov arab e d e f ne d a f o ow

C EO=CHAR= n d c at o rv arab e t h at e t t o one f t he

h arman of th e B oard a o t h e C EO

NUMMTGS= thenumberofboardmeetng heddur

ngthef ca yearExecuCompvarabe

Nummtg

FNANC NG=an e x an t e meau re of af rm d e re

fore x te rna f n anc n g t an n d c a

t o rv arab e c od e d 1f t h e f rm v arab e

FREEC ASH e t han 0 5an d 0o t h er

w e FRE ECASHt d e f ne d a

Cahfromoperaton Computatdata#308

AverageCaptaExpendturet 3tot1 data#128

C u rren t A e t t _ d ata# 4

7We a o c on du c te d ou ranay u n g t he mx of c omp en at on a ra t o c ompu te d a t he

BackSchoe vaueofexecutvetockoptongrant andthevaueofre trctedtockgrant

d vd e dby t h e ex e cu t v e t o ta c omp e n at on e a aryb on u t he v au e of t o c k op t on

gran t an d th e v au e of re t rc te d t o c k gran t n t h e y earp rort of rau d a t h e me au re of

themanager equtycompenaton ncentve Thecoeffcentonth mxof compenaton

v arab e p o t v e an d gn f c ant n b o th amp e w h e n n oc on tro are n c u d edp v au e

of 0001n t h e matc h ed amp e an d 00001n t he un mat c he d amp e n t h e p re e n ce of

ou rc on t ro v arab e t h e co e ff c e n t on t he mxv arab e b e c ome e gn f c ant a t h ough

t g n f ca nt a t t he 0 1 0 e v e p v a u e o f 0 07 n b ot h a m p e W e ex c ud e th e m x o f

compenaton fromourmante t becaueth varabedoe notrepreentthetheoretcaex

antencentveof management Wethanktherefereeforpontngth outtou



15/32


LEVERAGE=totadebt Computatdata#34+ #9

ca e d by t o ta a e t d a ta# 6

MARKETVALUEOFEQUTY=themarketvaueofequtyofthef rm

Computatdata#199tme #25

ALTMANSZ SC ORE =p roxyf orr k of f n an c ad t re c a c u

a t ed b a e d on A t man 1968a u pdat ed

byB e g e yMn g an dWat t 19968

BOOKTOMARKET=thebookvaueof harehoder equty

Computatdata#216d vdedbythe

marketvaueofequty

EARNNGSTOPRCE= netncomeComputatdata#172per

haredvdedby endofyear tockprce

RETURNONASSETS=netncomeComputatdata#172 d

v d e d byy eare n d a e t d a ta# 6

SALESGROWTH=thepercentagechangen ae Compu

tatdata#12 fromtheproryeartothe

currentyearforthefraudfrm from

twoyear prorto thefraudtotheyear

prorto thefraud

AGEOFFRM=t h e e n g th of t me n y e ar t h e f rmh a

beenpubc ytradedfromtheCenter

forReearchn SecurtyPrce CRSP

M&ANY EAROFFRAU D =an n d c a to rv arab e e t e q u a t o on e

f t h e f rmh ad an acq u t on t h at

c on trb u t ed t o a e n t h e p rory eara c

q u t on n t h e f rt y e arof f rau d f or

f ra ud f r m V ar a b e e t eq ua t o o n e

f d a t a#249> 0 o t he rw e v arab e e t

equa tozero

TOTALAS SETS =t h e f rm t o ta a e t d a ta# 6 F orf rm

ac c u e d of f rau d t o ta a e t are me a

ureda oftheyearprecedngthea

egedfraud

STOCKVOLATLTY= thetandarddevatonreturnvoat ty

ofreturncacuatedover60month

F orf rmav a ab e on E x ec uCompw e

ue thevarabeBS_VOLATLTY Forthe

f rm n ot ava ab e on E x ec uCompw e

computethevarabeu ngtheCRSP

databae

CEOTENURE=thenumberofyeartheCEOha been

theCEOofthecompanyForf rm

avaabe onExecuCompwecompute

We a o e t mate t h e reg re on u n g t he p roxyf ord t re a d e ve op ed by Sh umw ay

2001 andournference areunchanged



16/32


thetenurea thenumberofyear be

tweenthevarabe BECAMECEOandthe

currentyearforfraudfrm thecur

rentyear theyearprortofraud

Forfrm notavaabe onExecuComp

wecomputethevarabe nthe ame

manneru ngdataobtanedfromproxy

tatement

M SSNGC EOTENURE =an n d c at o rv arab e e t e qu a t o on e f

t h e CEOTENU REv arab e m n g an d

zerootherw e

We n c u d e t wog ov ern an c e varab e Th e f rt C EO=C HARH e rma n

andWe bach2001 arguethatthegreatetfactoraffectngtheBoard

ofDrector effectvene t ndependencefromtheCEOMoreover

DechowS oanandSweeney1996 fndthathavnga Charmanwho

mu t an e ou y t h e C EO n c re a e t h e k e h ood of man pu at ng e arn ng

We a o n c u de t h e n umberof b o ardme et n g NU MMTGS a ap roxyf or

themontorngandeffortcontrbutedbyd rector Adam 2000 Vafea

1 9 99 9

WencudeF NANCNGtocontro fortheneedtoobtanexterna

fnancngA FREECASHbecomemorenegatvethefrm become co erto

e xhau t n g t n t ern af und an d t hu h a an n c en t v e t oman pu at e e arn

n g n an t c p a t on of ac ce n g t he c ap t amarke t B e cau e t h e re a t on

n o t k e y n e ar w e f oow D e ch ow S o an an d Sw ee n ey 1996 an d c re a te

an n d c at o rv arab e e t e qu a t o on e f t h e f rmw k e yw ant e x te rna

f n anc n gw t h n t h e n ex t t woy e ar e FREEC ASH e t h an ore q ua t o

05 an d zero o t he rw e Th c u tof f aume t h at f af rmre q u re e x t er

n a f n anc n gw t h n t h e n ex t t woy e ar t w t art t ak n g act on n ow tora e

thederedfund

WencudeLEVERAGEandALTMAN Z coretocontro forthepo b

t y t hat f n anc a y d t re e d f rm h ave g re at e rn c en t v e t o c ommt f rau d

t h an f rm t h at are n ot d t re e d A t man 1968 B e g ey Mn g an dWat t

1996 We a o n c u de e v erap e rf orman c e met rc n ord ert o c on tro

fortheeffectofpoorf nancaperformanceorweakenedfnanca tab ty

Pooryperformngfrm mayreortto accountngfraudnordertocoverup

therdefcentperformanceSpecfca y wenc udeEARNNGSTOPRCE

BOOKTOMARKETandRETURNONASSETSa meauredn theyear

prorto fraudtocontro forfnanca performance WencudeMARKET

9 n add t on t o t he g ov ern an c e v arab e t e d abov e w e a o n c u de t h e Gov e rn anc e n

d e xme t rc c omp e dbyGompe r h an dM et rc k 2003 w he re ava ab e f orou rmatc h ed

amp e f rm Th v arab e ame au re of h areh od errgh t b ae d on 24c orp ora t e g ov e r

n anc e p rov on c o e c te d by t he n v e t orRe p on b t yRe e arc h C en t erB e c au e w e o e 18

ob e rva t on f romou rfraud amp e w e d on o t ret an t h v arab e n ou rman an ay e Ou r

nferenceareunchangedn theub ampeforwhchwe canncudeth varabe andthe

Gove rnan ce n d ex v arab e n o t gn f c ant n t h e t e t



17/32

128MERC KSON MHANLONAND E LMAY D EW

VALUEOFEQUTYtocontro for zeandSALESGROWTHtocontrofor

t h e po b t y t hat p ooryp e rformn g ow grow n gorh gh grow th f rm

may c ommt f rau dn ord e rt on c rea e o r u t an t h e r a e g row th 10We

a o n c u de AGEOFTHEFRM t oc on trof ort h e n c en t v e t o c ommt

f rau dp rovd e dby an n t a t o ck of fe rn g orbyh avn gn e w y u ed t o ck

F n ay w e n c u d e an n d c a to rv arab e M&AN Y EAROFFRAUD w h c h

tak e on av au e of on e f a p ort on of t h o e a e are f roman ac qu t on

Pror teratureprovdeevdencecon tentwthfrm managngearnng

p rort o an ac q u t on n orde rt ora e t h e rt o c k p rc e E rc k on andWan g

1 9 99 L ou 2 00 4

C omp e n at on t ruc t ure a c h o c e v arab e ou n g t a an e x p an a

t oryv arab e run t h e r k of e n dog en e t yp rob e m F ore xamp e n c a e

n w h c h mon torn g more d f f c u t f rm mayu e ah gh e re v e of n

c en t v e t o ck b ae d c omp e n at on D e me t zan dLe h n 1985Smt h an d

Watt 1992 GaverandGaver 1993andCore Hothauenand Larcker

1 99 9 t e xa ct y n t ho e c a e n w h ch m o n to r ng d f f cu t t ha t we

mgh t ao e x pe c t to e e ah gh e rk e h ood of f raudTh e p e c ay t rue

n t h e n t t u t on a e t t ng c on d e red n t h t u dy b e cau e ou re n t v t y

v arab e rep re e nt r k t h e e xe c ut v e b e ar n h c omp e n at on t ruc t ure

a t v are w t h t h e t o ck p rc e of t h e f rmf f rm provd e more n c en t v e

t h rou gh p ay r k w h en mon t orn g more d f f c u t an d f f rau d more

k e yw h en mon t orn g more d f f c u t t h en w e may e e t h e a o c a t on b e

tweenthe tructureofexecutvecompenatonandbengaccuedof fraud

mpyb e c au e mon torn g df f c u t n t he e f rm an dnot b e cau e t h e

tockbaedpayprovded ncentve formanager toengagenfraud

Wenc udeproxe forthedetermnantof equtyncentve a ndepen

dentvarabe nourregre onn anattempttocontrofortheendogenety

decrbedabove Wefo owthemodeofequty ncentve nCoreand

Guay1999 WencudeCEOTENUREandSTOCKRETURNVOLATLTY

10n add t on t on v e t g a t e w he t he rou ramp e of a e g ed f raud f rm h ad ow erg rowt h

durngthefraudperodwhch mayhaveedto therbengcaughtwe comparetheearnng

datatem#172 growthrate durngthefraudyearwth thoeofour matched ampeoff rm

Wefndthatthefraudfrm andnonfraudfrm ddnothave gnfcantyd fferentaverage

annuagrowthratedurngthefraudperod

11We re cogn ze t h at th e u e of an n t rume n ta v arab e V t w o t age e a t q u are ap p roa c h

thetandardtextbookfxforendogenety Howeverf ndngappropratentrument ex

t reme ydf f c u t an dw he n one u e n app rop ra t e n t rume nt t c an e a y b e t h e c a e t hat

t h e V e t mat e are more b a e d an dmore k e y t op rovd e t h e wrong t a t t c a n fe ren c e

than mpeOLSe tmate thatmakenocorrectonforendogenety LarckerandRutcu

2005 a o e e B oun dJaeg e ran dB ak e r1995 Th u w e d on ot mp e me n t a t wo t age

V e t mat on n ou rman t e t F u rt h er b e cau e t h e e nd oge n e ty n ou rt e t t h e corre a t ed

omttedvarabe typeofendogenetywecan ncudea etofdetermnant oftheendogenou

re gre orS ENSTV TY n ou rre gre on m t g at n g th e n c on t e nc y c au e d by th e c orre

a t ed omt t ed v arab e a umn gof c ou re w e t d on o t hav e a c o rre a t ed omt t ed v arab e

H owe v er w e n ot e t hat n t h e n t ere t of c omp et e ne w e e t mat e a t wo t age e a t q u are V

mode u n g t o c k p rc e a an n t rume nt f orS ENSTV TY n t h e t mat on t h e n f e re n ce

regardngthereatonbetweenfraudandequtyncentveare unchanged e no gnfcant

reaton



18/32


p rox e f ort he t w ov arab e n C ore andGu ay 1999 mode n o t n c u de d

n ou rmode f oro t h erre aon 2C EOTENU RE pred c t ed t ob e p o

t v e y re a t ed t o t h e e v e of e q u t yn c en t v e A d e c rb ed byC ore and

Gu ay 1999 ov ert me un ce rtan t y abou t aC EO ab t y re ov e dA r k

b orn e by t he C EOdue t oun ce rtan t y abou t h ab t y re du c ed t p o b e

t ompoe more n c e nt v e r k on h m c e te r p e rbu n add t on e q u t y

ncentve canbeued tomt gatehorzonprobem DechowandSoan

1991 oequty ncentve maybencreaeda retrementapproache

A d c u e d ab ov e D e me tzan dL e hn 1985 h ypo t he ze t hat f rm op

e rat n gn e p red c t ab e e n v ronme nt h ave h gh e rmon t orn g c o t an d

b e c au e of t h e e h gh e rmon t orn g c o t f rm n n o e re n v ron me n t w

h ave h gh e rman age raow n e rh pE x e cu t v e n f rm n w h c h mon t or

n g d f f cu t w k e y a o h a ve e a e r o pp or tu n t e t o c om m t f na nc a

accountngfraudThu wencudeSTOCKVOLATLTYa aproxyforth

uncertantyn ourregre on

43UNVARATETESTS

n t ab e 4 w e p re e nt d e c rp t v e t a t t c f ort he a e g ed f raud f rm

andbothampe ofnonfraudfrm matched ampeof100 nonfraud

frmsandtheunmatchedsampeof nonfraudfrms Foreachvarabewe

preentthemean tandarddevaton medanand owerandupperquar

t e V ar a b e t h at r ep re e nt d o a r a r e h o wn n m o n a n d a v ar a b e

arewnsorzedreset atthe1%and99% eves Forthef rmsaccusedof

f rau d a v arab e are me au red a of t he y e arp rorto t h e b egn n n gof t he

fraud

C omp arn g th e f rau d f rm w t h t he mat ch ed amp e of f rmre v e a e v

e ra gn f c ant d f f e re n ce n c on trov arab e b u t no t a t t c a y gn f c ant

dfferences ntheequ ty ncentvevarabesNotabed fferencesarethatthe

fraudfrmshaveah gherstockreturnvoat ty areon averageyounger

frm thathaveCEO wtha margnay hortertenurehavehgherSALES

GROWTHprortothefraudcommencngandhavemore nstancesofan

12 We include the BOOK TO MARKET ratio and MARKET VALUE OF EQUITYas described

above We contro for ndustry membersh p by matchng on ndustry n the matched sampe and

by including one-digit industry indicator variables in the unmatched sample Core and Guay

[1999] nc ude a varab e for free cash fow probems set equa to the rat o of operatng cash fow

ess dv dends to tota assets f the frm has ow growth opportunt es and zero otherwse The

varab e fo ows Jenson 1986 who argues that the combnaton of ow growth opportuntes

and hgh free cash fow creates agency probems that can be mt gated wth hgher eves of

equty ncentves Ths s the ony varab e n Core and Guays 1999 mode that s nsgnf cant

in their tests Because of its insignificance and because we already include a free cash flow

varab e fo owng Dechow, Soan, and Sweeney [1996] that serves as a proxy for the frms

externa f nancng needs and severa proxes for growth MARKET TO BOOK and SALES

GROWTH, we do not also include Core and Guays [1999] specific free cash flow variable

13We winsorize the matched sample variables over the distribution of the matched sample

plus alleged fraud firms 150 firms and w e winsorize the unmatched sample over the distri-

butonoftheunmatchedsampep usa egedfraudf rms13083f rms



19/32

TABLE4

DecrptveStat tc onFnanca StatementVarabe andMarketba edMeaure forFrm AccuedofFraudbytheSECandfortheMatchedandUnmatchedSampe

StandardLowerUpper nMeann Medan

Variable Mean Deviation Quartile Median Quartile (p-value) (pvalue)

SENST VTY

Accuedoffraud19063640 01460419 1644

M atc he d amp e 1513730401090342108403460127

U nmatc h ed amp e 1019220401230326087800920080

VESTEDSTOCKANDOPTONSENSTV TY

Accuedoffraud15373239 00920 3011136

M atc h ed amp e 1238661500590276078203740187

U nmatc he d amp e 0810193800750220062701190087

CEO=CHAR

Ac cu e d of f raud 0760431 00100100

M at c he d amp e 0760 431001001000 7910792

U nmatc he d amp e 0710 450001001000 4150415

NUMMTGS

A c cu e d of f rau d 7203654006 00900

M at c he d amp e 6993 245006008000 7470449

U nmatc he d amp e 7072 795006009000 8060502

FNANCNG

Accuedoffraud01400351 00000000 0000

M atc h ed amp e 0020014100000000000002810202

U n mat ch e d amp e 0032017700000000000000350001

LEVERAGE

Accuedoffraud02060184 00370 1850325

M atc h ed amp e 0184016100130176031404910587

U n mat ch e d amp e 0229017600700223034903470269

MARKETVALUEOFEQUTY$ MLLONS

Accuedoffraud50129011 5638716820 41210425696

M atc h ed amp e 5759751783623212515036627499008680858

U nmatc h ed amp e 371895924722346668811127746004330141



20/32

ALTMANSZSCORE

Accuedoffraud10711 12503890 8441422

M atc h ed amp e 1197140404510984167504140383

U nmatc he d amp e 1044105003670789135008610803

BOOKTO MARKET

Accuedoffraud00400 35301500 3250481

M atc he d amp e 0454034102520358055103800172

U nmatc h ed amp e 0487036402430409063300850018

EARNNGSTOPRCE

A c cu e d of f raud 00110107003000200050

M atc h ed amp e 0065058800150042006003800014

U nmatc he d amp e 0020012300180045006700690001

RETURNONASSETS

A c cu e d of f raud 00230178003500370087

M atc h ed amp e 0017033900210057008703040070

U nmatc h ed amp e 0042010200200051008900130022

SALESGROWTH

Accuedoffraud06501 38600640 2190607

M atc h ed amp e 0179034500270116025500220012

U nmatc h ed amp e 0188036900150102024900080001

AGEOFF RM

Ac cu e d of f raud 123913202507961851

M atc h ed amp e 18461988525963250100300043

U nmatc h ed amp e 206618995841442290100010001

M&ANYEAROF FRAUD

Ac cu e d of f raud 0300460 00000100

M at c he d amp e 0150 360000000000 0490031

U nmatc h ed amp e 015036000000 00000130001

TOTALASSETS$ MLLONS

Accuedoffraud390424 787000100 26281023 29446

M atc h ed amp e 414172972675136302784122360108851000

U nmatc h ed amp e 299432590917299397945825187504180008



21/32

TABLE4 Contnued

Standard Lower Upper in Mean i n Median

Variable Mean Deviation Quartile Median Quartile (p-v alue) (p-value)

STOCKVOLATLTY

Accused of fraud 0534 0 264 0334 0 482 0669

Matched sample 0.400 0.172 0.267 0.363 0.513 0.002 0.004

Unmatched sample 0.376 0.205 0.243 0.348 0.485 0.000 0.000

CEOTENURE

Accused of fraud 4820 5927 0 000 2500 9000

Matched sample 6.540 5.589 2.000 5.500 10.000 0.084 0.014


MSSNG CEOTENURE

Accused of fraud 0140 0351 0 000 0000 0 000

Matched sample 0.060 0.238 0.000 0.000 0.000 0.151 0.103


All monetary amounts are in $ millions. Variables are as defined as follows: SENSITIVITY is a measure of how much the value of the top five executives portfolio of stoc k options,

restricted stock and stock changes in response to a one percent change in stock price. This variable is measured using the methodology described in Core and Guay [2002]. For the

firms accused of fraud this variable is measured in the year prior to the alleged fraud. VESTED STOCKAND OPTION SENSITIVITY is a measure of how much the value of the top five

executives portfolio of exercisable stock options and unrestricted stock changes in response to a one percent change in stock price. This variable is measured using the methodology

described in Core and Guay [2002]. For the firms accused of fraud this variable is measured in the year prior to the alleged fraud. CEO = CHAIR is an indicator variable taking

the value one if the CEO is also the Chairman of the Board, and zero otherwise. NUMMTGS is the number of times the firm s board meets, annually. FINANCING is an indicator

variable set equal to one when the firms free cash flow divided by lagged current assets is less than -0.5 and zero otherwise. LEVERAGE is measured as the firm s debt divided by

total assets. For firms accused of fraud, IEVERAGE is measured as prior to t he fraud. MARKET VALUE OFEQUITY is the market value of shareholders equity. For firms accused of

fraud, it is measured the year prior to the alleged fraud. ALTMANS Z SCORE is a proxy for risk of financial distress calculated based on Altman [1968] as updated by Begley et al.

[1996]. BOOK TO MARKET is the book value of shareholders equity divided by the market value of shareholders equity. For the firms accused of fraud, the ratio is measured as

of the year preceding the alleged fraud. EARNINGS TO PRICE is the earnings to price ratio. For firms accused of fraud, the ratio is measured as of the year preceding the alleged

fraud. RETURN ON ASSETS is net income divided by assets. For the firms accused of fraud, the ratio is measured as of the year prior to the alleged fraud. SALES GROWTH is the

percentage change in sales from the prior year to the current year (for the fraud firms from two years prior to the fraud to the year prior to the fraud). AGE OFFIRM is the length

of time in years the firm has been publicly traded (from CRSP). M&A IN YEAR OF FRAUD is an indicator variable set equal to one if the firm had an acquisition that contributed to

sales in the prior year (acquisition in the first year of fraud for fraud firms). (Variable is set equal to one if data item #249>0, otherwise variable is set equal to zero.) TOTAL ASSETS

are the firms total assets. For firms accused of fraud, total assets are measured as of the year preceding the alleged fraud. STOCK VOIATILITY is the standard deviation volatility of

returns calculated over 60 months. For firms in the Execucomp database this variable is the BSVolatility variable in Execucomp. We compute the variable in the same manner for

the hand-collected firms. (CO TENURE is the number of years that the CEO has been CEO of the firm. For the firms in the ExecuComp database, the variable is computed as the

number of years between the variable BE(CAMECEO and the current year. For fraud years it is measured as the year prior to fraud. For hand-collected firms, we compute the variable

in the same manner using dates obtained from the proxy statement. MISSING CEO 7TENNURE is an indicator variable set to one if the CEO TENURE variable is missing for the firm. All

v arab e are w n orze d a t t h e 1% and 99% e v e A pv au e are f romt wot a e d t e t



22/32


ac qu t on o c cu rrn gn t h e f rt y e arof f rau d n t e rm of me d an df fe r

e n c e t he re u t are mar w t h t h e ex c ep t on of t he f raud f rm h avng a

owerEARNNGSTOPRCE

Thereareanumberofdfferencebetweenthefraudfrm andtheun

matc h ed amp e of f rm Wt h re gard t o t he c ompe n at on v arab e t h e

d a t an t ab e 4 n d c at e t hat S ENSTV TY n ot t a t t c a y d f f e re n t be

tweenthefraudfrm andtheunmatched ampeu ngatwota edtet

p= 0092 TheVESTEDSTOCKANDOPTONSENSTV TYofthefraud

f rm a o n o t t a t t c a y d f f e re n t fromt hat of t he f rm n ot a cc u e d of

fraud In terms of control variables, the fraud firms are again, on average,

youngerfrm theyhavehgherSALESGROWTHprortothefraudcom

mencnghavegreaterSTOCKVOLATLTY andhavemorentance ofan

ac qu t on o c cu rrn gn t h e f rt y e arof f rau d n add t on t h e f rau d f rm

onaveragehavea owerRETURNONASSETSandhaveagreater kehood

ofneedngexternaf nancngMedandfferenceare m arbut ndcate

thatthefraudfrm havefewerTOTALASSETS haveowerEARNNGSTO

PRCE andhaveowerBOOKTOMARKETrato Theoweraccountng

return andgreaterneedforexternaf nancngfortheaegedfraudfrm

c on t e nt w t h t h e d e a t hat t h e e f rmare omew hat t rou b e dp o

byprovd ngat eata partofthemotvatonforthea egedaccountng

fraud

44 MULTVARATETESTS

n t h e c t on w e e x amn e w he t he re x ec u t ve c ompe n at on a o c a te d

wtha egedaccountngfraudaftercontro ngforcorporategovernance

f a ct o r t he d e re f ore xt e rn af n an c n gp e rforman ce me trc f rm ze

returnvoat tyandotherfactor Theconceptua modeforthe ogtana

y a fo ow

PrFraud= f equtyncentve governance performancemetrc

external financing, other controls). (1)

Webegnw ththeanay ofthe50fraudfrm comparedwththematched

ampeoff rm notaccuedofaccountngfraud

441 M atc h ed S amp e Re u t Tab e 5p re e nt t h e re u t u n g t he

matc he d amp e d e gn Th e d e pe nd e nt v arab e e q ua on e f t h e f rm

wa accuedofaccountngfraudbytheSECandzerootherwe Nether

S ENSTV TY n orV E STED STOC KAND OPTONSENSTV TY gn f

c ant y a o c a t edw t h ac c oun t ngf raud n an y of t he re g re on w h c h we

e t mat e b ot h w t h andw t h out c ont rov arab e C oumn A an dB pre e nt

t h e re u t f ort h e S ENSTV TY v arab e w t h out an dw t h c ont rov arab e

re p e ct v e yC oumn C an dD pre e nt t h e re u t f ort he v arab e V E STED

STOC KAND OPTONSENSTV TY n ord ert o t e t t h e a o c a t on w t h t he

e q u tyh odn g t h at t h e e xe c ut v e c an e mmed at e yAmong t h e c on

t rov arab e STOC KV OLATLTY gn f c ant w h e t h e o t he rc ont ro



23/32

TABLE5

Reut ofaLogt Regre onComparng50Frm AccuedofFraudbytheSECwththeMatchedSampeofFrm

A B C D

PredctedCh SquareChSquareChSquareCh Square

VarabeS gnCoeffcentp-vaueCoeffcentp-vaueCoeffcent p-vaueCoeffcentp-vaue

NTERCEPT-07360000-20470107-07310 000-20400108

S ENSTV TY ? 0020032200010721

VESTEDSTOCKANDOPTONSENST VTY? 002103460 0080755

CEO=CHAR+ 01460 39101460 391

NUMMTGS -0033 0306 -0 033 0307

FNANCNG+ 047803760 4750377

LEVERAGE+2250 00842 2430084

MARKETVALUEOFEQUTY?0000 09420000 0961

ALTMANSZ+ 0310013003120129

BOOKTOMARKET?-03510 621-03550617

EARNNGS TO PRCE ? 2227 0443 2 220 0444

RETURNONASSETS?-01200 935-01120939

SALESGROWTH?08070 09608060096

AGEOFFRM--0013 0209-00130207

M&ANF RSTYEAROFFRAUD+0 474016904750 168

STOCK VOLATLTY + 2 729 0017 27291 0017

CEOTENURE? -00120770-001170769

MSSNG CEOTENURE? 139300571 39830056

Mode Lke hood Rato 1066 0302 34450 0005 0950 0330 34419 0005

N150150150150

Thstabe presentstheresutsof ogstcregressonswherethedependentvarabe san ndcatorvarabesetequa tooneforf rmsaccusedoff nanca accountngfraudand

z e ro o therws eOur s amp e ncud es 5 0 frms a c cused o ffna nc a a c co untng frms a nd 1 0 0 frms ma tched to the a eg ed fr a ud frms b a s ed o n nd us try 2 d g tS Cco d e y e ar a nd

frm sze tota assets n the year pror to the aeged fraud A varabes are defned n tabe 4 A p-vaues are two ta ed except where a sgn s predcted



24/32


v arab e are n gn f c ant Th e e re u t u gge t t h at onc e n du t ry and ze

havebeencontroedforv amatchnguncertantyntheoperatngenv

ronmenta proxedbySTOCKVOLATLTY theony gnfcantpredctor

offraud

442 U n mat ch e d S amp e Re u t n t h e c t on w e p re e n t t he re u t of

t h e ame t e t d e c rb e dn t h e pror e c t on bu t we n ow c omp are t h e 50

fraudfrm wththebroadunmatched ampe 13000+frm yearober

vaton ofnonfraudfrm wthdataonExecuCompTabe 6preent the

b a c r e g re o n re u t T he r e u t n t ab e 6 c o u mn A a nd C r e ve a a g

n f c an t yp o t v e a o c a t on b et w ee n f rau d an d SENSTV TY p =0007

andVESTEDSTOCKANDOPTONSENST VTY p= 0012 whennocon

t rov arab e are n c u de dn t h e re g re on Th u n a arge amp e w t h n o

ad d t ona c ont ro t h ere a t a t t c ay p o t v e a o c a t on b et w ee n e xe c

u t v e e q u typ ortf oo n c en t v e an d t h e k e h ood of c ommtt n gf rau d

We t he n ad d t he c ont rov arab e t o t h e re gre on B e c au e t h e amp e

un mat ch e dw e a o n c u de n du t ry f x e d e ff e ct a t t h e on e dg t S C e v e

coeffcent arenottabuatednthe nteret ofbrevty Afteraddngthee

c ont ro w e f n d t hat c on t en t w t h t ab e 5S ENSTV TY an dV ESTED

STOC KAND OPTONSENSTV TY are no t gn f c ant y a o c a t edw t h ac

c oun t n gf rau dp =0 266andp = 0242re p e c t v e yTh e c o ef f c e nt on

e v era c on trov arab e are gn f c ant F ore x amp e t he f raud f rm ge ne r

ay h ave h gh e rSTOC KVOLATLTY p=0005 on e t a e d an d are more

k e y t oh ave a e a t trb u t ab e t o an ac q u t on n t h e f r t y e arof f raudp =

0024on e t a e d

45 MANAGERALBENEFTSDERVEDFROMTHEACCOUNTNGFRAUD

We ao e x amn e e x p o t t o ck op t on e xe rc e an d t o c k ae t od et e r

mnewhetherthere evdencethatexecutve atfraudfrm od more

equtythanexecutveat nonfraudfrm Therearereaon tobe evethat

e v en f e q u tyn c e n t ve are a o c a te dw t h f rau d e x p o t t o ck ae an d

op t on e x erc e w ou dn ot b e a o c a t edw t h f raudF ore x amp e e x ec u

tve maynotwanttodrawattentontothefraudbyengagngn unuua

e v e of e n g n add t on f t h e f rau d p e rp e tra te dn ord e rt ob uy ome

tmetobecomeproftabeor ncreaenonfrauduentperformanceand

theexecutvedoe th wththebe efthattheyw notbecaught thenthe

e x ec u t ve w w ant t od e ay a e u n t t h e f rm prc e e v en h gh e rt han

w h at t d u rng t h e f rau dp erod F n ay e x ec u t ve c an u e t h e h are

a c o a t e ra f oro an t hu e x tra ct n gw e ath w t h out t h e a ct u a a e of t h e

t o ck F ort h e e re aon w e b e e v e t he e x an te me au re of n c e n t ve w e

u e n ou rman an ay p rovd e ab e t te rt e t of ou rre e arc h q ue t on H ow

e v e rw e p e rformt he t e t on a e of h are an d e x erc e of t o c k opt on

forcompetene

Toprovdeempr caev denceonthee queton wecompareopton

e x erc e t o ck ae an d cah c omp en at on ov ert h e f rau dp erod f ort he

f rau d f rm re at v e t o th e n on f rau d f rm We re port t he e re u t n t ab e 7



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TABLE6

Reut ofaLogt Regre onComparng50Frm AccuedofFraudbytheSECwththeUnmatchedSampe

A B C D

PredctedChSquareCh SquareCh SquareCh Square

VarabeS gnCoeffcentp-vaueCoeffcent p-vaue Coeffc entp-vaueCoeffcentp-vaue

NTERC EPT5 703000070840000 5684000070950000

S ENSTV TY ? 0 101000700600266

VESTEDSTOCKANDOPTONSENSTVTY ?0109 00120067 0242

CEO=CHAR+ 059600410 6000040

NUMMTGS -0027 0299 -0 026 0306

FNANCNG+ 084800520 8480052

LEVERAGE+-0760 0199-07550200

MARKETVALUEOFEQUTY ?00000 29900000228

ALTMANSZ +-02570 062-02560062

B OOKTOMARKET? 045203390 4550337

EARNNGSTOPRCE?2 2 2 2 0 1 7 4 2 2 3 2 0 1 71

RETURNONASSETS?-29190 052-29160052

SALESGROWTH?03710 17203720171

AGEOFF RM-00180068-00180 067

M&ANF RSTYEAROFFRAUD+ 0 6 6 8 0 0 24 0 6 6 6 0 0 2 4

STOCKVOLATLTY +1849 00051 8610005

CEOTENURE?-00220 407-00220401

MSSNG CEOTENURE?02860 52502770540

Mode Lk e h oodRat o5246002267824000046090032679340000

N13083130831308313083

h t ab e p re e n t t h e re u t of og t c re g re on w h e re t h e d ep e nd e nt v arab e an n d c a t orv arab e e t e qu a t o on e f orf rmye ar w h ere t he f rm ac cu e d of f n an c a

a c cou nt n gf rau d an d zero o t he rw e Ou ramp e n c u de 50f rm ac cu e d of f n an c a a c c ou n t ngf raud an d 13033f rmyear a o t he rf rmye ar on E xe c uC ompf orw h c h n o

accusatonoffraud smade A varabesaredefned ntabe 4 Onedg t ndustrynd catorvarabesarenc udedn theregressonestmatonbutcoeffc entsaresuppressedabove

f or mpc t y A pv au e are t wot a e d e x c ep t w he re a gn p red c t ed



26/32

TABLE7

StockOptonExerc e StockSae andCahCompenatondurngFraudPerod

A egedFraudFrm veru MatchedSampeA egedFraudFrm veru UnmatchedSampe

A egedFraudMatchedA egedFraudUnmatched

Frm Sampe Sampe Dfference p-vaue F rm Sampe Sampe Dfference p-vaue

StockOptonExerc e

#opton exercedt/#exerc abeopton t

Mean 244% 273% -29% 0645 244% 229% 15% 0774

Median 07% 94% -87% 0009 07% 52% -4 5% 0085

# op t on e x e rc e d t/ # t o ta op t on h e d t 1+# op t on grant t

Mean 74% 83% -09% 0640 74% 88% -14% 0411

Medan 08% 40% -32% 0009 08% 22% -14% 0049

# op t on e x e rc e d t/# op t on e x erc e d t +# e n dn g e x erc ab e op t on t

Mean 123% 143% -20% 0396 123% 132% -09% 0643

Median 17% 68% -51% 0017 17% 41% -24% 0 079

$ re a z e d f rome x erc e t / $ re a z e d f rome x erc e t + n trn c v au e of e x erc ab e op t on t

Mean 225% 219% 06% 0 873 225% 200% 25% 0414

Median 30% 102% -72% 0115 30% 75% -45% 0369

StockSae

# n e t h are od t /# h are h e d t 1

Mean 03% 29% -26% 0258 03% -06% 0 9% 0664

Medan 00% 00% 00% 0363 00% 00% 00% 0783

$ v au e of n e t h are od t / $vau e of h are h e d t 1

Mean 12% 29% -17% 0389 12% -05% 1 7% 0365

Median 00% 00% 0% 0816 00% 00% 00% 0538



27/32

TAB LE 7 C ont n u ed

Alleged Fraud Firms versus Matched Sample Alleged Fraud Firms versus Unmatched Sample

Alleged Fraud Matched Alleged Fraud Unmatched

Firm Sample Sample Difference p-value Firm Sample Sample Difference p-value

C ah C ompe n at on durn gF raudP e rod n $m on

Saary+ bonuoverfraudperod

Mean $4.478 $3.742 $0.736 0.104 $4.478 $3.142 $1.336 0.001

Median $2.434 $2.804 -$0.370 0.716 $2.434 $2.506 -$0.072 0.331

S a ary +b onu c a e d by ave rag e t ot a a e t ov e rt he f raudp e rod

Mean 0.7% 0.7% 0.0% 0.957 0.7% 0.5% 0.2% 0.113

Median 0.4% 0.4% 0.0% 0.377 0.4% 0.3% 0.1% 0.425

Saary+ bonu+ otherca hcompenatonoverfraudperod

Mean $5.217 $3.960 $1.257 0.022 $5.217 $3.295 $1.922 0.001

Median $2.854 $2.917 -$0.063 0.489 $2.854 $2.562 $0.292 0.108

S a ary +b onu +o t he rc ah c ompe n at on c a e d by av erage t o t a a e t

Mean 0.7% 0.7% 0.0% 0.834 0.7% 0.5% 0.2% 0.046

Median 0.4% 0.4% 0.0% 0.534 0.4% 0.3% 0.1% 0.692

Difference in means p-values is based upon a t-test, while difference in medians is based upon Wilcoxon signed rank test. Variables are defined as follows: #

options exercisedt is the variable SOPTEXSH from ExecuComp; exercisable optionst_- is the variable UEXNUMEX from ExecuComp; total options heldtl

is the sum of the variables UEXNUMEX and UEXNUMUN and current grants is the variable SOPTGRNT from ExecuComp; $ realized from exercise is the

variable SOPTEXER from ExecuComp and the intrinsic value of exercisable optionstl is the variable INMONEX from ExecuComp. Salary and Bonus are

both from ExecuComp variables of the same name. Assets are taken from Compustat (data item #6). For stock sales we gathered the data from Thompson

Financial Insider Filing Data Feed. The number of shares sold is the net of acquisitions (negative values) and sales, excluding sales of shares just gained from

option exercise (positive values) (variable NSHR). The shares held are as of the beginning of the year (SHRHELD). The value of the transactions is computed

as the stock price at the time of the sale or purchase (TPRICE) multiplied by t he number of shares in the transaction. All variables are summed over the top 5

executives for ExecuComp variables and over all officers for Thompson variables. All variables are winsorized (reset) at 99% and 1%.



28/32


Wefndno evdencethatfraudfrmexecutveexerc e tockopton mea

ured nnumberofopton andvaue toagreaterdegreethanexecutve

atthenonfraudfrm netherthematched ampeor theunmatched am

pe Forexampefraudfrm executve exerceapproxmatey24%ofther

begnnngoftheyearexercab eopton whe thematchedunmatched

ampeexecutveexerc e27% 23% Themedannonfraudfrmexecu

tveactuay exerc edmoreopton thanthemedanfraudfrm executve

d u rn g th e f rau dp erodh ow e ve rt h e e re u t are on ymargn ay gn f

cantfortheunmatched ampe Tabe7 a o ndcatethatfraudfrmexec

u t v e d on o t e gn f c ant ymore me au red a t t h e mean an dmed an of

ther tockhodng thandomanager atnonfraudfrm

nterm ofcah compenaton wefndthatfraudfrmexecutve earned

on av erage $ 448m on p ery e arove rt he f raudp e rodn t e rmof a ary

an db on u an d $ 522m on p ery e arove rt he f raudp e rodn t e rmof

totaca hcompenaton14Wth theaveragenumberofyear offraudfor

ou ramp e b e n g 23 y e ar t h t ran at e n t o t h e t op f v e e x e cu t v e n ou r

av erage f rme arn n g abou t $ 12m on d o ar n t o ta c ah c ompe n at on

wheperpetratngthefraud ncontrat theexecutve atthematched

amp e of f rme arn ed on y $ 396m on p e ry earon av erage n t o ta c ah

c omp e n at on du rn g t h ame p erodTh df f ere nc e gn f c ant a t t h e

002e v e b u t t he me d an are n o t gn f c ant ydf f e re n t p =0 49 n

ordertocontro for zedfference we caethecompenatonmeaure

by t h e t ot a a e t of t h e f rmAf t erd on g t h w e f n dn o e vd en c e of a

tatt ca dfferencen theannua cahcompenatonof thefraudfrm

comparedwththematchedampeof nonfraudfrm durngthefraud

perodanda0 2%dfferenceon average nthe caedmeaurere atveto

theunmatched ampe p= 0046

We n t e rp ret t h e d at an t ab e 7 a f a n g t ou pp ort t h e c on c u on t h at

fraudfrmmanager exerc edmore tockoptondurng thefraudperod

t h an ddman age ra t n on fraud f rm Sm ary c on t e nt w t h t h e f n dn g

ofDechow Soan andSweeney1996 wenterpretthedata ntabe7 a

f a n g t ou pp ort t h e con c u on t h at fraud f rmman age r odmore of

ther tockhodng thanddmanagerat nonfraudfrm

5C on c u on

Weexamnewhetherthencdenceofa egedaccountngfraud a oc

atedwthexecutveequtyncentve Someofthearget accountngfraud

n h t ory o c cu rre dn t h e a t e v eray e ar e adng t o t h e w e k now n up

heava ntheaccountng ndutryand weepng eg atveandreguatory

c h ang e Th e e e ve n t h ave e ft e g a t or re gu at or p rac t t on er an d

academc earchngforcaue oftheefraud Undertandngtheundery

n gf orc e t h at g av e r e t o t h e e f rau d an e ce aryp re cu rort o e f fe c t ve y

14 Total cash compensation is computed as the sum of the variables salary + bonus + all other

payfromExecuComp



29/32

140MERC KSON MHANLONAND E LMAY D EW

preventngfutureoccurrence Manyhave uggetedthattheexpanaton

e nthencentve andopportunte forperona ganfacedbyexecutve

Ou ramp e c on t of f rm e xp c t y ac c u e d of a cc oun t n gf rau dby t he

SECdurngtheperodJanuary1996toNovember2003Afterrequrngthe

av a ab t y of c ert an f n anc a d a ta w e h ave af n a amp e of 50f rmt h at

wereaccuedof fraudbytheSECwhchweca thefraudfrm Wecompare

t he f raud f rm w t h t w oamp e of f rm t h at w e re n o t a cc u e d of f rau d

F rt w e c omp are t he f raud f rm w t h amat ch e d amp e of f rm n w h c h

t h e mat ch e are b a e d on ze y e aran dn du t ry S e c on dw e c ompare t he

f rau d f rm w t h an un mat ch ed amp e of f rmc on t n g of a re man n g

frm yearon ExecuComp

Weet mateavaretyofequty ncentvemeaure forthetopfveexecu

t v e a t e a c h f rmf oc un g p e c f ca y on t h e e xp e ct e d ch ang e n v au e of

theexecutve tockandoptonbaedportfoo toa1% tockprcechange

whchwedenote en tvty naddt onaanay e weexamnewhether

t h ere e v d en c e th at ex e cu t v e a t f rm ac cu e d of f raud y t e mat c ay

e t o ck an d e xe rc e op t on du rn g t h e pe rod of t he a e g ed f raud t o a

greaterextentthanexecutve nthematchedandunmatched ampe of

contro frm

Th e e mprc a an ay re ve a n o c on t e nt e v d e nc e t ou pp ort t h e con

c u on t hat t he p robab t y of ac count n gf rau d n c re an g n t h e e n t v t y

ofexecutve totaequtyor veted tockandtockoptonba edweathto

c han ge n t o ck p rc e We a of n d t h at man age ra e x e rc e of t o c k op

t on an dman ag e ra t o ck ae are n ot gn f c ant yh gh e rf orf raud f rm

t h an f orn on f rau d f rm Th u t h e e re u t t and n c ont ra t t o a e rt on

bypo cymaker thatncentvefrom tockbaedcompenatonandthere

u t n g e q u t yh odn g n cre a e t h e k e h ood of ac count n gf rau d

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