We examine whether the structure of executive compensation, specifically stock options relative to other forms of pay, is associated with opportunistic use of discretionary accruals in reported earnings. Prior research suggests that using options creates an incentive to temporarily depress the firm's stock price prior to the option award date, thereby lowering the exercise price of the options. We hypothesize, and find evidence, that relatively high option compensation is associated with income-decreasing discretionary accrual choices in periods leading up to option award dates. Furthermore, we find that this association is stronger when managers are able to publicly announce earnings prior to the option award date. Our results are consistent with the general implication from prior research that option compensation creates opportunistic incentives for managers to time the release of good and bad news to the market.
Managers' systematic influence on accounting policy is well documented in the earnings management literature. Recent studies in the “management of information” line of research suggest that such influence is exhibited in financial reporting more generally, including supplemental disclosures in proxy statements. Using 1996 compensation data, I extend recent research on how firms report the value of options paid to their CEOs. I conduct several tests of the argument that potential political costs of unexplained compensation explain cross-sectional variation in how aggressively firms report option awards. Even after incorporating several variables not considered previously, I find strong support for the assertion that firms whose CEOs receive unexplained pay relative to performance tend to report lower grant date values for their CEOs' option awards. The evidence also suggests that the tendency to report lower grant date values is stronger for firms under more scrutiny from institutional owners. Contrary to previous research, I find that unexplained pay also increases the likelihood that the firm will choose grant date reporting methods (over the allowable alternative) in their proxy disclosures. I interpret the overall results as consistent with the argument that political costs related to compensation influence options reporting. The findings have implications for accounting standard-setters and for researchers who rely on estimates of option values reported in proxy statements.
In 1993, Congress passed Internal Revenue Code Section 162(m), which eliminated the tax deductibility of nonperformance-based executive compensation over $1 million. Recent research indicates that, as intended, Code Section 162(m) has strengthened the link between executive pay and firm performance.
Although 162(m) apparently has changed executive compensation in a way desired by Congress, we hypothesize that 162(m) has indirectly influenced the financial-reporting process. Specifically, we hypothesize and find evidence to support the following: for numerous reasons associated with “qualifying” a compensation plan per Code Section 162(m), executives in firms that qualify their compensation plans receive relatively low pay when their firm's financial performance is extreme. Because these executives receive relatively low pay for extreme financial performance, an incentive exists to smooth reported earnings over time in order to maximize long-term compensation. The relatively smooth earnings patterns that we observe in qualified firms are related to the use of discretionary accruals.
Our results appear robust to alternative sampling and modeling techniques. As such, our evidence suggests that a tax policy designed to curb allegedly excessive executive compensation has indirectly affected the quality of reported earnings.
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