Performance-Vested Stock Options and Earnings Management

Yu Flora Kuang

The University of Melbourne

May 2008

Journal of Business, Finance & Accounting, Forthcoming

This paper investigates the effects of performance-vested stock options (PVSOs) on the propensity of managers to engage in earnings management. Using observations from the 240 largest non-financial firms in the UK, I show that managers are more likely to engage in earnings management when they hold a larger proportion of their compensation in PVSOs. When categorizing PVSOs on the basis of their distance from the end of performance periods, the results show that managerial incentives to manage earnings mainly stem from PVSOs that are granted in prior years but within a performance evaluation period (i.e., PVSOs before vesting). Moreover, vesting targets influence the relationship between earnings management and PVSO compensation. The findings are consistent with the earnings smoothing hypothesis: confronted with more ambitious vesting targets, managers who are heavily loaded with PVSOs before vesting will report higher performance by generating greater accounting accruals, whereas in years with good performance, these managers will have incentives to reduce current reported performance by managing earnings downward so they can increase earnings as needed in the future.

Keywords: Performance-vested stock options, equity incentive, earnings management

JEL Classification: J33, M41, M43

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Date posted: May 20, 2008  

Suggested Citation

Kuang, Yu Flora, Performance-Vested Stock Options and Earnings Management (May 2008). Journal of Business, Finance & Accounting, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1135105

Contact Information

Yu Kuang (Contact Author)
The University of Melbourne ( email )
Level 7, The Spot
198 Berkeley St
Carlton, Victoria 3053
+61383449361 (Phone)
+61393492397 (Fax)
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