Question

Empirical research shows that the existence of stock options may induce earnings management (Alexander et al., 2017). Discuss this claim.

Answer 1

Stock-based compensation is designed to align the interests of executives with those of shareholders. A large body of evidence suggests that stock-based compensation indeed enhances firm value. However, mechanisms that ensure incentive provisions inevitably induce executives to engage in earnings management. In equilibrium, investors can perfectly infer the true earnings; still, executives cannot avoid the costly earnings management because if they do not manipulate, they suffer deep price losses. Thus, earnings management is a deadweight loss. Additionally, more extensive use of ESOs (a greater number of ESO grants or a lower exercise price) intensifies earnings management. As a result, earnings management is more severe when there are more exercisable (vested) in-the-money stock options. Everything else being equal, restricted stock induces more earnings management than stock options. Restricted stock is required to be expensed while executive stock options are not. Hence, restricted stock dilutes the existing shareholders’ wealth more than stock options. Moreover, as opposed to restricted stock holders, stock option holders are typically not entitled to receive dividends. Thus, a CEO compensated mainly by stock options may tend to distribute less dividends than is optimal