Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis by Ohad Kadan, Jun Yang

Executive compensation has changed in the aftermath of the corporate governance "crisis" (where we saw Enron, Tyco, Adelphia, WorldCom and others fall precitously due to accounting scandals). One such change is a shift away from stock options. Microsoft is the classic example but many other firms have also scaled back option progams for restricted shares (share that can not be sold for some period).

The restricted shares are better than options view is summed up by the AFL-CIO in a WSJ piece from 2003:

The AFL-CIO has submitted shareholder resolutions at American Express Co. and five other businesses urging a ban on stock options for senior executives and greater use of restricted stock. Labor officials call performance-linked restricted stock "a better motivator of performance," says the AFL-CIO's Brandon Rees.

However, that is not the final word. Kadan and Yang suggest that restricted shares may actaully worsen the earnings management problem and be more costly than traditional option grants.

Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis

How? They begin by showing that restricted shares are really little more than option grants with a strike price of zero. They then

"...show that lowering the exercise price (increasing the moneyness) of options intensifies earnings management. Therefore, for the same number of grants, restricted stock induces more earnings management than stock options. Additionally, using numerical examples, we show that to induce the same level of effort, optimally-designed stock options induce less earnings management and cost less to the firm than restricted stock. "

Very interesting.

Here are some more "visual bites":

• "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"
• "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." --This is presented more rigorously as their second propostion (page 13): Both the expected earnings management and the expected cost of earnings management strictly decrease in the exercise price K, strictly increase in the number of ESO grants, and strictly decrease in the stringency of the accounting standards....Proposition 2 is the main theoretical result used in our empirical analysis. It implies that the more in-the-money the option is, the higher the extent of induced earnings management. Everything else being equal, stocks induce more earnings management than options."

So it is very possible that the change to restricted shares (ie. in the money options) may lead to further accounting problems. Kadan and Yang investigate this empirically using cross sectional regressions where they measure the effect of restricted share usage on distretionary accruals. Their findings fit existing theories very well!

" a larger amount of stock-based compensation in year t induces managers to lower the earnings in this year. Perhaps, during the grant year, managers manipulate earnings downwards in order to better the conditions of the grants (to lower the exercise price) or to save accruals for future vesting years....bonus payments induce more earnings management, which is consistent with prior research; see, for instance, Healy (1985).... In contrast, salary payments appear to mitigate earnings management, perhaps, due to the wealth effect. Interestingly, the CEOs with longer tenures tend to manipulate earnings more. Moreover, large firms tend to have more discretionary accruals consistent with the observation in Coffee (2003). Firms with more growth opportunities and lower current operating performance are engaged in more earnings management, in line with Larcker and Richardson (2004). Not surprisingly, firms with a higher stock return have less incentives to manipulate earnings"

Which deserves a WOW!

I^3! (a rarity for a paper that still has some parts undone!)

Cite:

Kadan, Ohad and Yang, Jun, "Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis" (March 15, 2005). AFA 2006 Boston Meetings Paper http://ssrn.com/abstract=615881