Does Equity-based Compensation Cause Firms to Manage Earnings Per Share?

Abstract

Equity-based compensation causes increases in firms' share count and dilutes Earnings Per Share (EPS), which provides firms with an incentive to raise EPS using either share buybacks or earnings management. We employ a regression discontinuity framework to provide evidence of a causal link between equity-based pay and EPS management. Our tests compare firms experiencing dilution from ``just-in-the-money'' option exercises with firms whose options end up narrowly out-of-the-money. We find that firms engage in real- and accruals-based earnings management, but not buybacks, to boost EPS around these plausibly exogenous dilutive events. These effects are stronger when executives' bonuses depend directly on EPS.

Keywords: executive compensation, earnings per share, equity incentives, option exercises, regression discontinuity, dilution, earnings management, share repurchases

JEL Classification: G30, G35, J33, M43