Ebook Executive Stock Options and Earnings Management: A Theoretical and Empirical Analysis
Aimed at aligning the interests of executives and shareholders, stock-based compensation has become the key component of executive compensation over the past two decades. The recent corporate scandals, however, have spurred regulators, investors, and scholars to reexamine the implications of stock-based compensation on shareholder wealth.
Stock-based compensation, on one hand, motivates executives to take real actions to increase firm value. On the other hand, it induces executives to engage in earnings management, which is essentially the difference between the firm’s reported earnings and the economic earnings. This research examines the trade-off between these two effects, focusing on the comparison between restricted stock and stock options two important, yet arguably controversial components of executive compensation. Hereafter, we will refer to compensation by restricted stock and stock options as Executive Stock Options (ESOs), since restricted stock can be considered a special case of stock options when the exercise price is zero.
This paper addresses the following questions. How do ESOs affect executives’ reporting? In particular, do restricted stock and stock options affect reporting differently? How should compensation committees design ESOs trading off incentives and earnings management? And ultimately, how do regulatory changes affect earnings management and the design of ESOs?
We propose a three-stage principal-agent model. In the first stage, investors (the principal) design an ESO contract. In the second stage, executives (the agent) choose effort levels that determine the distribution of earnings. In the third stage, executives report earnings, and the stock price is determined based on the earnings report. Executives may manipulate the report trading off the benefit of a higher option value and the cost of misreporting. The contract design in the first stage takes the executives’ effort choice and reporting strategy into consideration.
Given that it is costly to engage in earnings management, the executives will only do sowhen the gains from a higher stock price exceed the costs. One main result is that lowering the exercise price of the options induces more earnings management. Essentially, lowering the exercise price makes the options more in-the-money, and hence the marginal benefit from an increased stock price is higher. For this reason, it is more likely that the cost of earnings management will be outweighed by the benefit from the boost in stock price. As an extreme case of stock options, restricted stock is always in-the-money regardless of the stock price. Consequently, restricted stock induces more earnings management than do stock options. A second main result is that increasing the number of ESO grants intensifies earnings management. Intuitively, increasing the number of ESO grants magnifies the extent of stock-based compensation; thus, it is more likely that the benefit from an increased stock price will exceed the cost of earnings management. Additionally, we show that earnings management for both restricted stock and stock options will be mitigated by improved accounting standards that severely penalize executives for misreporting.
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