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AbstractThis study focused on fraudulent financial reporting, one of the most serious forms of corporate governance failure, and investigated whether there is an association between the likelihood of fraud, and independent directors' stock-option and cash compensation. Logistic regression analysis based upon a sample of 111 fraudulent companies and 111 matched non-fraudulent companies indicated a significantly positive association between director stock-option compensation and the fraud likelihood. On the other hand, there is no association between the fraud likelihood, and independent directors' cash compensation and stock ownership. These findings imply that companies may want to compensate their independent directors with cash and stock ownership, rather than options, to better align directors' long-term interests with those of shareholders. This implication is applicable not only to North American and European companies but also companies in an emerging Asian economy where there is a trend to compensate independent directors with stock options.Keywords: Fraud, Stock Option, Director Compensation, CEO Compensation, Corporate GovernanceJEL Classification: G30 (Corporate Finance and Governance - General)IntroductionMassive fraudulent financial reporting at Enron, Healthsouth, Parmalat, and WorldCom are just a few examples of corporate governance failure to stop corrupted management and the associated destruction of company value. Such failure clearly reflects a serious agency problem between corporate managers and shareholders who rely on independent directors to monitor managers. Critics, however, assert that certain compensation structure for independent directors may have misaligned the interests of directors and shareholders, thereby attributing to the corporate governance failure (Chowdhury, 2009). In other words, an improper director compensation structure could potentially lead to a secondary agency problem at the board level. In response to this problem, regulators and stockholders have since re-examined corporate governance and director compensation. Excessive cash compensation of independent directors may be symptomatic of an environment of mutual back scratching or cronyism where directors and top executives do not care about shareholder interests (Brick, Palmon, & WaId, 2006). On the other hand, stock options, which enable option holders to buy the company stock at an option exercise price that is below a stock market price, are more valuable if the underlying stock is more volatile (Diamond, 2006). This option provides incentives to a chief executive officer (CEO) whose compensation is dependent on options to engage in much greater risk-taking than a genuine representative of stockholders likely would (Ryan & Wiggins, 2002; Sanders & Hambrick, 2007). Likewise, stock options could make independent directors place too much emphasis on short-term profit growth, and ignore excessive risk taking of CEOs as long as it increases short-term stock price and their stock-option value (Diamond, 2006; Jensen, 2005). When legitimate business operational results can no longer justify the price of stock, these CEOs may turn to accounting manipulation and even fraudulent practices to continue the appearance of short-term profit growth, which affects an appreciation in stock and option values (Goldman & Slezak, 2006). Given the desire to increase the value of their stock options, independent directors may fail to scrutinize questionable/fraudulent conduct of these executives (Higgs, 2003; New York Times, 2007).This study attempted to verify this assertion by examining a potential association between the likelihood of fraudulent financial reporting and independent directors' stock-option and cash compensation. Independent directors, defined in accordance with the NYSE and the NASDAQ Corporate Governance Rules, are individuals who have no material relationship with the company or its top executives. …
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