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Corporate governance, stock options and earnings management

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  • Bo Sun

Abstract

Firms often compensate executives with stock options when empirical studies find that these contracts lead to severe earnings management problem. In order to understand the use of stock options as a prevailing compensation strategy in practice, we derive the optimal contract between a firm's shareholders and its manager, the latter of whom exerts unobservable effort and is privately informed about economic earnings as well as his own expertise in managing earnings. The optimal contract is characterized analytically in different corporate governance systems. The model indicates that the inactive region below a threshold in the compensation should be more economically significant when the corporate governance is weaker. The model suggests that, while the use of options leads to earnings management incentives, it is an optimal contract in the presence of reporting latitude and uncertainty over an executives' ability to manage earnings. The model result is in accordance with the observed positive association between the level of earnings management and the use of stock options in both time series and cross section. Empirical evidence on the changes in the intensity of option grants in executive compensation in response to corporate governance legislations also lends support to the model.

Suggested Citation

  • Bo Sun, 2012. "Corporate governance, stock options and earnings management," Applied Economics Letters, Taylor & Francis Journals, vol. 19(2), pages 189-196, February.
  • Handle: RePEc:taf:apeclt:v:19:y:2012:i:2:p:189-196
    DOI: 10.1080/13504851.2011.570707
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    References listed on IDEAS

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    1. Shirley, Mary M & Xu, Lixin Colin, 2001. "Empirical Effects of Performance Contracts: Evidence from China," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 17(1), pages 168-200, April.
    2. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 113(3), pages 653-691.
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    4. Bergstresser, Daniel & Philippon, Thomas, 2006. "CEO incentives and earnings management," Journal of Financial Economics, Elsevier, vol. 80(3), pages 511-529, June.
    5. Burns, Natasha & Kedia, Simi, 2006. "The impact of performance-based compensation on misreporting," Journal of Financial Economics, Elsevier, vol. 79(1), pages 35-67, January.
    6. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, vol. 98(2), pages 225-264, April.
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    Cited by:

    1. Wei Shan & Ran An, 2018. "Motives of Stock Option Incentive Design, Ownership, and Inefficient Investment," Sustainability, MDPI, vol. 10(10), pages 1-19, September.

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