Hypotheses on Earnings Quality and Management Stock Options

The necessity to build compensation plans that deal with the problem of managers manipulating performance measures has led many authors to propose theoretical models in the search for the ideal characteristics of contracts. One of the aspects commonly cited in studies is the length of incentives. The horizon of the incentives granted by a management stock option compensation plan depends on the vesting conditions of contracts, which might vest immediately, in one year, in two or more years, constantly over time (e.g.: 25% per year during four years) etc. (Cadman et al., 2012). Longer vesting times are associated with long-term incentives, while option grants that completely vest immediately or in a short period are associated with short-term incentives. Nevertheless, contracts might include a mix of short and long-term incentives.

In a theoretical scenario in which the manager can inflate current earnings at the expense of long-term performance, in order to reduce or to eliminate manipulation, a firm’s long-run returns must influence the manager’s compensation (Edmans et al., 2012). The model of Edmans et al. (2012) indicates that for the complete elimination of manipulation by managers, the firm’s performance should influence manager’s compensation even after his retirement. An intuitive insight from this model is that ESOP should grant long-term incentives in order to avoid short-termism by managers. This implies that a manager’s compensation should be sensitive to a firm’s long-term performance for manipulation incentives to decrease.

Additionally, Peng and Röell (2014)’s model shows that a manager’s payment horizon must be longer when short-term information is not reliable. Considering that stock prices can be manipulated, and that EM might be one of the mechanisms utilized by managers to influence the market, contracts that include long-term incentives in their mix could be preferable in order to reduce manipulations associated with ESOP short-term based incentives. Hence, the authors show that allowing long-term incentives shifts part of the incentive pay from the short term to the long term, leading to better effort choices. Accordingly, Marinovic and Varas (2019) study ideal contracts and conclude that under the possibility of manipulation, CEOs' optimal contracts involve a mix of short and long-term incentives.

Considering that stock options can bring incentives for manipulation by managers, one can presume that contracts based on short-term metrics will lead to more manipulation and EM by managers than contracts that include long-term incentives, because, as Peng and Röell (2014) state, on the long run the “truth” will come out. Given the difficulty to sustain manipulations for long periods, these contracts can lead to smaller incentives for managers to try this sort of practice. Accordingly, Gopalan et al. (2014) suggest that incentives that last longer lead to lower positive discretionary accruals levels.

Given that managers whose contracts are based exclusively on the short-term should present higher manipulation incentives, we presume that this kind of contract will be associated with lower earnings persistence, after all, discretionary accruals (or EM) are one of the main explanations for earnings that are not persistent (Xie, 2001). Hence, we suppose that contracts that yield long-term incentives (contracts that include options that take longer to vest), mixed with short-term incentives or not, should lead to higher earnings persistence and higher accruals persistence. To test this premise, we develop the following hypotheses:

H1: Firms that include long-term incentives in their ESOP will present more persistent earnings than those that do not.

H2: Firms that include long-term incentives in their ESOP will present more persistent accruals than those that do not.

Although we expect short-term-based stock option contracts to incentivize managers to manipulate accounting information, reducing EQ, we also investigate some issues related to the timing of manipulation. We review empirical studies in order to obtain insights regarding this issue.

2.3.2 Hypotheses on Discretionary Accruals

Aboody and Kasznik (2000) analyze a sample of 2039 stock option grants to CEOs by 572 firms between 1992 and 1996, focusing on firms that had scheduled grant dates. They propose that managers anticipate the release of bad news to the market through voluntary reports released prior – but close - to the grant date. They also suggest that managers delay good news. These manipulations on the timing of information disclosure allow CEOs to have options with smaller exercise prices at the date of grant and higher sale prices at their vesting time. The results presented by the authors not only lead to the conclusion that CEOs try to manipulate the market through voluntary disclosures, but also lead to the belief that the market and the analysts are influenced by those attempts of manipulation.

From the results presented by Aboody and Kasznik (2000), one can assume that knowing the grant date of stock options makes managers attempt to manipulate the market in order to obtain higher gains. Considering this premise, Baker et al. (2003) test the hypothesis that managers negatively manage their earnings close to the stock options grant date in order to reduce their stock options exercise price. Analyzing a sample of 168 firms listed on the Wall Street Journal annual compensation survey during the period of 1992 to 1998, they find results consistent with this hypothesis and reveal that, options granted to managers in the current year affect discretionary accruals negatively in the previous year. In order to identify whether this happens similarly in an emerging country like Brazil, we have developed the following hypothesis:

H3: The level of executive stock options granted in the year following accounting earnings release affects current year Discretionary Accruals negatively.

Given the expectation that managers will manipulate accounting negatively before the stock options grant date, one can assume that managers will positively manage earnings close to the date in which options vesting period ends. Accordingly, Chan et al. (2010) observe that managers of firms with higher Discretionary Accruals present higher levels of exercisable options than firms that have smaller levels of inflated earnings.

Bartov and Mohanram (2004) observe that positive abnormal earnings in the period prior to the exercise of options turn into bad performances in the period after the options exercise, which is due to the reversion of inflated earnings. The authors conclude that senior executives manage earnings to increase their gains.

Accordingly, Bergstresser and Philippon (2006) observe that the levels of EM were higher in firms on which CEOs presented stock price-related compensation. High accruals are coincident with periods on which there is a higher number of exercised options. The results of this study reveal that ESOP bring an incentive for the opportunistic manipulation of accounting earnings by executives.

These findings are consistent with the hypothesis that managers paid through stock options find themselves pressured to raise the market value of stocks close to the date when their options vesting period ends. Considering this premise, we have developed our fourth study hypothesis:

H4: The number of exercisable executive stock options in the year following accounting earnings release affects current year Discretionary Accruals positively.

If we do not reject hypothesis 4, there will be evidence that managers try to maximize their compensation through earnings management, which does not necessarily imply the maximization of shareholders’ interests. Even for long-term contracts, the proximity to the vesting date of options can bring incentives for managers to manipulate their payment metrics.

However, contracts that include options that vest in the long-term incentivize managers to spend less time and resources on manipulations related to short-term incentives (Peng, & Röell, 2014).

Hence, we argue that contracts based exclusively on short-term incentives will yield higher levels of earnings management and present the following hypothesis:

H5: The positive effect of the level of exercisable executive stock options on Discretionary Accruals will be higher for firms that do not present long-term contracts.

2.3.3 Hypotheses on Target Earnings

In the last section, we have presented our third hypothesis, which indicates that stock options granted in the year following the accounting earnings release affect prior year discretionary Accruals negatively. This hypothesis assumes that managers expect negative market reactions in response to lower earnings. However, it raises an interesting question: how much do managers have to deflate earnings for stock prices to go down? An intuitive answer to this question is that managers will try to report earnings that do not meet specific targets just before large option grants. This intuition is quite simple, because, as we have discussed, when managers do not meet or beat target measures such as analysts’ forecasts, previous year earnings or the “zero earnings target” (they present a loss), bad market reactions are expected (Graham et al., 2005; Gleason & Mills, 2008; McAnally et al., 2008; Dechow et al., 2010; Mindak et al., 2016). Hence, slightly not beating these measures could also indicate low EQ.

Based on the premise that managers will try to reduce their stock options exercise price, McAnally et al. (2008) study a sample of firms that adopt fixed date stock option grants and find that they are more prone to missing earnings targets when larger options grants are expected. They also find that EM plays a role in missed targets. We test whether this behavior occurs in the Brazilian capital market for different target measures.

H6a: larger executive stock options grants in the year following the accounting earnings release increase the probability that a firm will miss the “zero earnings” target.

H6b: larger executive stock options grants in the year following the accounting earnings release increase the probability that a firm will miss its last year earnings.

Overall, these hypotheses are quite intuitive. Considering that managers might desire to reduce their stock options exercise price, failing to meet earnings benchmarks might be a very effective measure, because it creates uncertainty regarding a firm’s prospects and might be interpreted as a signal of deeper problems at a firm (Graham et al., 2005).

Other than these measures, target-beating behavior also occurs when firms utilize EM to beat analysts’ expectations, because market returns tend to be negative when firms do not meet or beat analysts’ consensus forecasts (Gleason & Mills, 2008). However, given the limited data for the Brazilian capital market – especially for the subsample of firms that have adopted ESOP, we do not test whether firms intentionally miss these forecasts in order to increase their ESOP-related gains. In the next section, we present our last hypothesis, which deals with the relationship between executive stock option contract characteristics and Earnings Smoothness.

2.3.4 Hypothesis on Earnings Smoothness

The last measure of EQ that we analyze is Earnings Smoothness. This measure, estimated as the standard deviation of earnings scaled by the standard deviation of cash flows (Dechow et al., 2010; McInnis, 2010), indicates how much of a firm’s cash flow volatility is smoothed by earnings. If a firm’s earnings are less volatile than its cash flows, this ratio will be smaller, indicating that earnings are smoother. Overall, managers state that they might desire smooth earnings because they find it more interesting to sacrifice potential long-term value than to present earnings that are too volatile (risky) or hard to maintain in the long-term (Graham et al., 2005).

Some studies suggest that the existence of an ESOP and the structure of option contracts could create incentives for managers to smooth earnings (Grant et al., 2009). Grant et al. (2009) find that risk-taking incentives might lead CEOs to try to reduce a firm’s “apparent” risk through earnings smoothing in order to appeal to institutional investor preferences.

Additionally, Shu and Thomas (2015) find that higher holding of options by managers leads to higher smoothing of past earnings, because managers try to reveal information that might help investors to predict future earnings or in order to hide the firm’s past earnings volatility.

As previously discussed, manipulation is very common in the real world (Aboody &

Kasznik, 2000; Baker et al. 2003; Bartov & Mohanram, 2004; Bergstresser & Philippon, 2006;

Peng & Röell, 2014; Biggerstaff et al., 2015; Marinovic & Varas, 2019; among others). Hence, we have discussed that manipulation incentives should be higher when management stock option contracts rely solely in short-term incentives (Peng & Röell, 2014).

Long-term incentives are supposed to deal with the problem of manipulation. However, optimal contracts do not necessarily lead to zero manipulation, because it might be too costly to do so (Marinovic & Varas, 2019). Nevertheless, the term “manipulations” is not always pejorative, as it applies also to cases in which the manager seeks to signal the truth to the market (Peng & Röell, 2014). Long-term contracts eliminate the losses associated with manipulation.

However, they expose the agent to extra risks when long-term volatility is high or if the agent is risk averse. Hence, managers with long-term contracts might desire to smooth earnings in order to signal the firm’s average earnings, excluding the effect of transitory cash flows. They might also desire to reduce earnings volatility, because it can be associated with a higher risk by institutional investors. Nevertheless, we suggest that:

H7: Firms that include LT incentives in their ESOP will present smoother earnings.

Our hypothesis follows a simple intuition: managers with long-term incentives will try to signal their firm’s real average earnings by manipulating accruals in order to exclude the effect of transitory changes in cash flows. This tactic has the advantage of keeping earnings predictable and reducing investors’ perception of volatility and risk.

3 Methodology