Determining Selective Manipulation

The popularity of basing executive pay on a company’s performance has sparked concerns about the veracity of annual financial reports required by the federal government.

However, a C. T. Bauer College of Business finance professor’s new research finds that shareholders may actually benefit from manipulated financial reporting.

In "Lying to Speak the Truth: Selective Manipulation and Improved Information Transmission," forthcoming in the Journal of Finance, Judge Elkins Professor of Finance Paul Povel and a co-author report that such financial reporting isn’t necessarily a negative for a firm and its investors

“We find that even if manipulation can easily be prevented, shareholders may not find it optimal to do so,” they write. “Instead, shareholders may benefit from incentivizing managers who expect their firms to perform well in the long run to manipulate an unfavorable short-term report. Such selective manipulation can make the report more informative about the manager’s performance, thereby lowering the incentive compensation required to motivate the manager to exert costly effort.”

Povel explains further: “Only managers who know that their firm’s fundamentals are healthy and that a disappointing intermediate performance is undeservedly bad should be given an incentive to manipulate report upwards. That is achieved by offering bonuses contingent on achieving both high reported performance and high realized performance. A pessimistic manager who expects to realize low performance would then have no incentive to manipulate.”

The research authors stress that because manipulation is costly for many reasons, the optimal effects are realized only under specific circumstances: when a manager’s decisions have only a moderate effect on the firm’s performance and the expected negative valuation by manipulation is not too large.

In contrast, manipulation should be prevented when managers are highly productive or the expected value destruction caused by manipulation is large.

“To implement ‘selective manipulation, firms can use claw-back provisions or performance-vesting stock awards,” Povel said.