Earnings management and stock options

This paper tests for earnings management on the part of executives around key dates over the timeline of an option, namely grant and exercise. To test for earnings management at grant date, I hypothesize that earnings management in the form of income-decreasing accruals takes place in the period leading up to grant date. The lower the market price is on the date of grant, the lower the exercise price of the option. This will eventually lead to a higher cash payout when the executive exercises his options and sells the underlying shares. My results support this hypothesis. To test for earnings management at exercise date, I separated between those executives selling their underlying shares immediately (in the same 30 day period following the report date of quarterly earnings) and those that do not. In the first portfolio, I hypothesize that earnings management in the form of income-increasing accruals takes place in the period leading up to exercise date. Executives selling their underlying shares immediately after exercise will realize a higher cash payout if the market price on the date of exercise is higher. My results support this hypothesis. In the second portfolio, I hypothesize that earnings management in the form of income-decreasing accruals (due to the tax incentive associated with non-qualified options) takes place in the period leading up to exercise date. My results do not support this hypothesis, possibly due to the inclusion of options other than those deemed non-qualified as per the tax code. Overall, my findings suggest that earnings management does take place in the periods leading up to option grant and exercise. Such earnings management is motivated by the executives' desire to maximize the cash payout related to their stock compensation.