Earnings Management Choices When Stock-Option Incentives Conflict*

Abstract

Prior research suggests that managers use income-increasing (decreasing) accruals to increase the value of their stock option exercises (grants). I extend this research by modeling firms' accrual choices when incentives from stock options conflict and are confounded by other stock option features. I find that when incentives to maximize the values of option exercises (unvested options) and option grants (vested options) conflict, firms select accounting accruals to maximize the value of option exercises (unvested options). Surprisingly, despite the presence of vested options, firms use income-decreasing accruals in order to increase the value of option grants.

Keywords: Agency theory, stock options, earnings management, accruals

JEL Classification: G34, M41, M52