Risk‐Taking Incentives and Earnings Management: New Evidence*

Abstract

We reexamine the positive association between stock option vega and earnings management previously documented by Armstrong, Larcker, Ormazabal, and Taylor (2013; henceforth, ALOT). In contrast to ALOT, prior empirical research and practitioner literature emphasizes earnings management's goals of increasing stock price and reducing volatility. Specifically, we assess whether the association is robust to (i) employing discretionary accruals that are less prone to misspecification, (ii) focusing on a more recent time period, and (iii) including additional controls for period-specific factors. Our main findings are as follows. First, we fail to find a positive association between vega and earnings management after controlling for performance-related misspecification in discretionary accruals. Second, we find no association between vega and earnings management in a more recent time period, suggesting the results of ALOT may be sensitive to period-specific factors. Last, the positive association vanishes when we control for year fixed effects, growth opportunities, or monitoring, suggesting the original results of ALOT's research may be sensitive to correlated, omitted variables. Overall, our results question the extent to which vega incentivizes earnings management. Our results may be of interest to boards of directors in designing executive compensation contracts, to regulators in crafting policies that maintain high levels of financial reporting quality, and to researchers seeking to identify settings where earnings management incentives are most salient.

Equity incentives and conforming tax avoidance

“…We provide detailed variable definitions in Appendix . We control for year fixed effects in all specifications to alleviate concerns about period‐specific shocks confounding our results (Milidonis & Stathopoulos, 2014; Brick et al, 2012; Mayberry et al, 2021), and we cluster standard errors at the firm level.…”

Managerial Ability And Earnings Management: Moderating Role Of Risk-Taking Behavior

“…Managers will adjust earnings volatility by engaging in earnings management. Previous studies find that risk-taking behaviour leads managers to engage more in the REM (Alharbi et al, 2021;Billings et al, 2020) and AEM (Mayberry et al, 2021).…”

“…(Billings et al, 2020) also find that risktaking behaviour increases REM to achieve an option-based compensation target. (Mayberry et al, 2021) find that managerial incentive leads risk-taker managers to engage in AEM.…”

The predictive ability of tax contingencies for future income tax cash outflows

“…Consistent with the resource-based view of the firm, theory and empirical evidence suggests it is important to control for idiosyncratic unobservable features of firms that likely drive tax uncertainty (Belnap et al, 2023). To determine the appropriate fixed-effect structure in our models, we follow Hausman (1978) and compare the model's coefficients with firm fixed effects versus random effects (Hoopes et al, 2012;Lourenco, 2016;Mayberry et al, 2021). 12 To the extent coefficient estimates significantly differ, omitting firm fixed effects would result in model misspecification.…”