What Incentivizes Managers to Engage in Financial Misreporting? An Analysis of Stock Delta, Option Delta, and Vega

Abstract

Previous studies have provided mixed evidence on the relation between managers’ equity incentives and financial misstatements. These studies often measure equity incentives with the sensitivity of a manager’s stock and option portfolio to changes in equity price (i.e., portfolio delta) and/or the sensitivity of her option portfolio to changes in equity risk (i.e., vega). We hypothesize and find that the mixed results are attributable to the measurement error in portfolio delta because option compensation causes a manager’s incentive structure to be convex while stock compensation makes it linear. Splitting the portfolio delta into stock delta and option delta, we provide evidence that option delta has a dominating effect over stock delta and vega in explaining the likelihood and extent of financial misstatements. We also find that the positive association between option delta and misreporting variables is mainly driven by the effect of CEO’s option delta rather than that of CFO’s option delta. Our findings contribute to the literature by revealing the differential effects that stock delta, option delta, and vega have on providing managers with incentives for financial misreporting.