Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis

47 Pages Posted: 9 Nov 2004  

Ohad Kadan

Washington University in Saint Louis - John M. Olin Business School

Jun Yang

Indiana University - Kelley School of Business - Department of Finance

Date Written: December 10, 2005

Abstract

We study the effect of the grants of executive stock options and restricted stock on earnings management and insider trading during the vesting years of these grants. In our theoretical model, an informed manager compensated by stock options (which include restricted stock as a special case) is mandated to issue an earnings report. Uninformed nvestors price the stock based on this report. The manager can manipulate the report to affect the stock price, but earnings management is costly to the manager. The optimal report balances the benefits from the exercised stock options and the costs of earnings management. Earnings management and insider trading occur only if the options are in-the-money post manipulation at the vesting date, and are intensified by larger grants. Consequently, both earnings management and insider trading will be more severe in periods of high stock prices. Our empirical tests focus on the link between the timing and attributes of option grants and the extent of earnings management and insider trading. Our empirical results confirm that (1) deeply in-the-money executive stock options lead to more earnings management and insider trading at the vesting years of the options; (2) more grants of options intensify the extent of earnings management at the vesting years; and (3) earnings management and insider trading are more prevalent when stock prices are high due to high past returns.

JEL Classification: J33, M41, M43, G38

Suggested Citation

Kadan, Ohad and Yang, Jun, Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis (December 10, 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=615881 or http://dx.doi.org/10.2139/ssrn.615881

Ohad Kadan

Washington University in Saint Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Jun Yang (Contact Author)

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States
812-855-3395 (Phone)
812-855-5875 (Fax)

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