PDF Ebook Outside Directors’ Equity-based Compensation and Earnings Management
The past two decades have witnessed a rapid growth of option-based and stock-based compensation for corporate directors. According to Executive Compensation Reports, only about 1.6% of the 1,000 largest companies in the US offered equity-based compensation for directors in 1983, but by 1994, about 20% of firms did. Another survey conducted by Mercer Human Resource Consulting of 350 major companies reports that about 50% of firms offered stock options to directors in 1996, and about 80% did so in 2001 (Lublin and Bulkeley 2006). Similar to executive pay, outside director equity-based compensation has been a subject of heated debate, triggered by an unprecedented number of accounting and governance scandals in recent years. In this study, we examine how equity-based compensation for outside directors affects the board’s monitoring effectiveness over the financial reporting process as reflected in the extent of earnings management.
Boards of directors serve as an important mechanism to monitor senior management and reduce agency costs arising from the separation of ownership and control (Fama and Jensen 1983). Among other tasks, boards are responsible for overseeing firm accounting, auditing and internal control to ensure the integrity of financial reports. Board compensation, particularly performance-based compensation, can influence directors’ monitoring incentives. There are two competing views regarding the impact of equity-based compensation on directors’ monitoring effectiveness. Firms that rely on options and stocks to compensate outside directors argue that exposing directors’ wealth to the firm’s stock price is an effective way to align directors’ interests with those of shareholders. Some institutional investors and shareholder activists also advocate performance-based compensation such as option and stock awards for directors. Supporting this view, Yermack (2004) and Bryan and Klein (2004) show that the cross-sectional patterns of stock and option awards to outside directors conform to agency and contracting theories. In addition, Fich and Shivdasani (2005) and Becher et al. (2005) find that equity-based compensation for outside directors increases shareholder value. If equity-based compensation motivates outside directors to more effectively monitor executives and deter managerial opportunism, then greater equity incentives for outside directors would reduce opportunities for manipulation of accounting information and improve the integrity of financial reports.
On the other hand, in the aftermath of the accounting and governance scandals, some critics contend that equity-based compensation compromises directors’ independence in overseeing corporate financial reporting. Outside directors may not directly involve in earnings manipulation, but some of them may know and choose to go along with such activities when they also benefit from manipulated earnings. For example, a Wall Street Journal article reports that “critics have claimed directors, motivated to boost returns on their stock options, turned a blind eye to problems” for firms with accounting irregularities including Enron and WorldCom (Lublin and Bulkeley 2006). The New York Times reports that in 2001, Enron’s board received the seventh highest director compensation in the country with the majority of pays coming from options and stocks (Abelson 2001). The article also cites lawsuits accusing Enron’s outside directors of selling large quantities of shares in the three years prior to the fall of the company. The view expressed in these business press articles implies a positive relation between equity incentives for outside directors and the extent of earnings management.
In this study, we examine the above two conflicting views by investigating the association between outside directors’ equity incentives from option and stock holdings and the extent of earnings management. We find that firms of which outside directors have greater stock option incentives are less likely to report earnings that meet or just beat analysts’ forecasts and are less likely to consistently meet or beat analysts’ forecasts over consecutive quarters. In addition, stock option incentives for outside directors are negatively associated with both the level of abnormal accruals and the likelihood of reporting income-increasing abnormal accruals. We next model option incentives as a function of firm-specific economic determinants and decompose option incentives into the predicted and residual components. We find that the component predicted by economic determinants, not the residual value, is responsible for the deterrence of earnings management. Overall, the evidence suggests that stock option compensation improves outside directors’ monitoring effectiveness in reducing opportunistic financial reporting behavior. On the other hand, we do not find consistent evidence that outside directors’ stock holdings are associated with the extent to which their firms engage in earnings management.
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PDF Ebook Outside Directors’ Equity-based Compensation and Earnings Management
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