Executive Stock Options, Missed Earnings Targets and Earnings Management

Posted: 27 Jun 2007

See all articles by Mary Lea McAnally

Mary Lea McAnally

Texas A&M University - Department of Accounting

Connie D. Weaver

Texas A&M University - Department of Accounting

Anup Srivastava

University of Calgary - Haskayne School of Business

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Abstract

This paper examines whether stock option grants explain missed earnings targets, including reported losses, earnings declines and missed analysts' forecasts. Anecdotal evidence and surveys suggest that managers believe that missing an earnings target can cause stock-price drops (Graham, et al. 2006). Empirical studies corroborate this notion (Skinner and Sloan 2002, Lopez and Rees 2002). Thus, a missed target could benefit an executive via lower strike price on subsequent option grants. Prior option-grant studies explore only general downward earnings management (Balsam et al. 2003, Baker et al. 2003) but our study is the first to explore whether option grants encourage missed earnings targets. Indeed, if missed targets drive the prior results, the literature has failed to document an important negative outcome of stock option incentives. We use quarterly and annual data for fixed-date options granted after firms announce they have missed earnings targets. We find that firms that miss earnings targets have larger and more valuable subsequent grants. Further, we find that the likelihood of missing earnings targets for firms that manage earnings downward increases with stock-option grants. To control for the possibility that firms miss earnings targets for operational reasons, we only include firms that likely managed earnings downward (Dechow et al. 1996, Phillips et al. 2003). Backdating or opportunistic timing of grants cannot explain our results because we include only fixed-date grants. While many studies explicitly consider whether and why managers meet or beat earnings targets, ours is the first study to find that some managers may seek to miss earnings targets (Burstahler and Dichev, 1997).

Keywords: Stock Options, Earnings Management, Miss Earnings Targets, Book-Tax Difference, Meet or Beat Targets, Backdating Option Grant Dates, Earnings Distribution, Accruals, Deferred Tax

JEL Classification: H25, J33, M41, M43, M52

Suggested Citation

McAnally, Mary Lea and Weaver, Connie D. and Srivastava, Anup, Executive Stock Options, Missed Earnings Targets and Earnings Management. Accounting Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=996868

Mary Lea McAnally (Contact Author)

Texas A&M University - Department of Accounting ( email )

430 Wehner
College Station, TX 77843-4353
United States
979-845-5017 (Phone)
979-845-0014 (Fax)

Connie D. Weaver

Texas A&M University - Department of Accounting ( email )

430 Wehner
College Station, TX 77843-4353
United States

Anup Srivastava

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

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