The Association Between Stock Option Awards And The Use Of Earnings Management Tools: Evidence From Firms Targeted For Stock Option Backdating Investigation

Abstract

In the recent stock option backdating scandal, shareholders have discovered that executives were awarding themselves options in-the-money, which if the options were exercised, would reduce shareholders' wealth by the difference between the exercise price and the at-the-money price. If executives have no qualms about transferring wealth from shareholders to themselves, were they as easily willing to manage earnings to mislead shareholders and other firm's stakeholders? Using stock option backdating as a proxy for management opportunism, I examine the association between the compensation design and the use of earnings management tools to manipulate financial reporting for firms that are targets of investigation for stock option backdating. To examine this relationship I analyze a sample of 271 firms, from the June 14,2007 Glass Lewis & Company Report, for the period 1998 to 2006. These firms areassociated with stock option backdating in the sense that they are either under investigation for stock option backdating by the Securities Exchange Commission, the Department of Justice or the Internal Revenue Service, or they started an internal investigation into their own stock option granting practices. Following extant studies I use three measures of compensation: bonus, stock options and total compensation and a comprehensive set of earnings management tools, to analyze the association between the differences in the compensation structures and aggressive use of earnings management tools. I contribute to the literature on executive compensation that suggests that the explosion in stock option awards, where managers have large stock option holdings, has exacerbated the agency problem. The literature suggests that large stock option awards, instead of aligning the interest of management with that of shareholders, has provided incentives for management to manipulate the financial reporting process.