Financial Misreporting and Executive Compensation: The Qui Tam Statute

Abstract

A purported dark side to powerful equity-based incentives is that they may induce the manager to manipulate stock prices by distorting information. Recent theories predict that firms will grant more equity-based incentives to their managers when the detection of such information manipulation is more likely. We use the Qui Tam statute as an experimental setting to test this prediction. The Qui Tam statute gives whistle blowers in the healthcare industry large financial incentives to reveal corporate fraud, thus increasing the detection likelihood of information manipulation. Controlling for previously identified characteristics, we find that the extent of managerial equity-based incentives is around 9% higher in the healthcare industry than other industries. Further, as CFOs have the primary responsibility of the financial reporting process, we expect the effect of qui tam to be more pronounced for CFO incentives than for that of the other executives. Consistent with our prediction, we find that the healthcare industry’s effect on managerial incentives is the strongest for the CFO (13%), followed by the CEO (5%) and then by other executives. Using a difference-in-difference design, we find that the difference between CFO incentives and CEO incentives as well as the difference between CFO incentives and other executives’ incentives is larger in the healthcare industry than other industries. We also use the presence of a Big Five auditor as an alternate measure of the higher likelihood of detection of financial statement misrepresentation and find consistent evidence. Our collective evidence appears consistent with theories that predict that the detection likelihood of information manipulation affects the structure of executive compensation and in particular that of the CFO.