Real Earnings Smoothing and Managerial Compensation Incentives

Abstract

We provide empirical evidence that managers smooth earnings using discretionary R&D spending (i.e., real smoothing) when managerial compensation packages contain high risk-taking incentives. Specifically, we find that real smoothing is related to both the sensitivity of executive wealth to a unit change in stock price volatility (vega, capturing executives’ incentive of increasing R&D investment of high risk in nature) and the sensitivity of executive wealth to a unit change in stock price (delta, capturing executives’ incentive of preserving stock price possibly through reducing R&D investment). Given the empirical regularity of the extremely high correlation between vega and delta, we use Vega-to-Delta ratio to capture the net risk-taking incentive of executives, and find evidence supporting our hypothesis that the real smoothing is less for firms whose executives have high risk-taking incentives driven by their option compensations.

Keywords: Real earnings management; Executive compensation; Stock options; Risk taking

JEL Classification: M41; M52