CEO Risk-Related Incentives and Income Smoothing
61 Pages Posted: 26 Mar 2007 Last revised: 18 Apr 2009
Date Written: March 2, 2009
We investigate whether risk-related incentives of executive stock option (ESO) compensation plans are associated with income smoothing. Given that risk has both potential benefits and costs, including possible losses and/or large fluctuations that affect reported financial outcomes, flexibilities in financial reporting enable a manager to make apparent risk lower while masking the underlying real risk. As such, income smoothing can be a means by which a manager can reduce the unintended consequences of risk taking without at the same time reducing its intended consequences. Using a sample of approximately 7,000 firm-years, we find that risk-taking incentives and income smoothing are positively related. Our results are robust to alternate specifications of income smoothing and risk-taking, and to various firm-level characteristics, including governance structures, CEO share and option holdings. Additionally, we find that our results are especially pronounced in firms whose risk and risk-taking behavior are high.
Keywords: income smoothing, earnings management, CEO risk incentives, compensation risk, CEO compensation structure
JEL Classification: M41, M43, G34, G30, G32, J33
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