Executive Equity Mix, Earnings Manipulation, and Project Continuation

This paper studies the optimal design of long-term executive equity compensation when boards of directors make project termination decisions based on accounting information and executives can take costly actions to manipulate this information. The model shows that incentives for manipulation (i) persist even though the optimal contract requires the CEO to hold his equity for the long run (i.e., through long vesting periods) and (ii) decrease with a shift in emphasis from stock options towards restricted stock. In addition, the paper analyzes how the optimal equity mix and the level of manipulation change when the financial reporting environment changes. Specifically, the model predicts that the magnitude of manipulation is an inverted U-shaped function of the CEO’s opportunistic reporting discretion. Thus, in countries in which accounting standards are lax (tight) and governance controls are weak (strong), taking steps to limit reporting discretion will increase (reduce) the level of manipulation. With respect to CEO equity pay, the model predicts that firms University of Texas at Austin. Email: [email protected]. I thank Robert Goex, Christian Laux, and Paul Newman for their valuable comments.