How Rank and File Equity Compensation Affects Earnings Management

Equity compensation is a beneficial tool when it motivates employees to engage more intensely in performance-enhancing activities. One negative consequence of equity compensation, however, is that it provides incentives to manage earnings (i.e., to strategically present financial reports or structure transactions in order mislead financial statement users about financial performance). Earnings management may sacrifice long-term firm value for short-term financial results, and prior research provides evidence that earnings management is more prevalent when executives have greater levels of equity compensation (e.g., Armstrong, Larcker, Ormazabal, & Taylor 2013).

Our forthcoming study in the Journal of Business Finance & Accounting extends prior research by examining the link between earnings management and equity compensation granted to rank and file employees (i.e., non-executives). Understanding this link is important because, while executives receive the largest equity grants, the majority of equity grants are awarded to employees who are not listed among firms’ five highest compensated executives (Ouyang & Sallehu 2015). Additionally, recent studies provide evidence that rank and file employees can make a significant impact on firm outcomes such as financial reporting. For instance, rank and file education level is positively correlated with financial reporting quality (Call, Campbell, Dhaliwal, & Moon, 2017), and rank and file equity grants are associated with a decreased propensity for employees to blow the whistle on fraud (Call, Kedia, & Rajgopal, 2016).

We use rank and file employees’ option-based compensation as a proxy for equity compensation. We find that increases in rank and file employees’ equity compensation are associated with increases in earnings management. Further, we find that this relation is attributable to real earnings management (e.g., granting excessively lenient credit terms and over-producing inventory) as opposed to accruals-based earnings management (i.e., altering accounting judgments to affect financial statements). This result provides support for the idea that rank and file employees have greater opportunity than executives to engage in real earnings management because they work more closely with business processes (Oberholzer-Gee and Wulf 2012).

To provide additional support for our findings, we examine factors that may strengthen or weaken the link between rank and file equity compensation and earnings management. We find that the relation between rank and file equity compensation and earnings management is stronger in firms with fewer employees, where the performance incentives of equity compensation (and consequently the earnings management incentives) are greater because employees are less likely to engage in free riding and because mutual monitoring is more effective (Hochberg & Lindsey, 2010). We also find that the relation between rank and file equity compensation and earnings management is weaker in the presence of good corporate governance, as measured by increased board independence.

Our results provide insight to those responsible for designing compensation packages. We expect that firms spend a significant amount of time determining executive equity compensation grants. Our study suggests that equity compensation grants for rank and file employees can also have a significant effect on firm-level earnings management. We caution, however, that our results do not speak to the optimality of rank and file equity compensation, as the associated incremental earnings management may be more than offset by greater productive efforts encouraged by option compensation. Rather our results point to increased focus on financial reporting quality by monitors when rank and file employees receive substantial equity grants.

REFERENCES

Armstrong, C. S., Larcker, D. F., Ormazabal, G., & Taylor, D. J. (2013). The relation between equity incentives and misreporting: The role of risk-taking incentives. Journal of Financial Economics, 109(2), 327–350.

Call, A. C., Campbell, J. L., Dhaliwal, D., & Moon, J. R. (2017). Employee Quality and Financial Reporting Outcomes. Journal of Accounting and Economics, 64(1), 123–149.

Call, A. C., Kedia, S., & Rajgopal, S. (2016). Rank and file employees and the discovery of misreporting: The role of stock options. Journal of Accounting and Economics, 62 (2–3), 277–300.

Hochberg, Y. & Lindsey, L. (2010). Incentives, targeting, and firm performance: an analysis of non-executive stock options. Review of Financial Studies, 23(11), 4148–4186.

Oberholzer-Gee, F. & Wulf, J. (2012). Earnings management from the bottom up: An analysis of managerial incentives below the CEO. Working paper available at: http://ssrn.com/abstract=1982528

Ouyang, W. & Sallehu, M. (2015). How do broad-based stock option grants affect firms’ overall future productivity? International Journal of Business and Finance Research, 9(2), 21–38.

This post comes to us from Professor Kip Holderness at West Virginia University, Adrienna A. Huffman at The Brattle Group, and Professor Melissa F. Lewis-Western at Brigham Young University’s Marriott School of Business. It is based on their recent article, “Rank and File Equity Compensation and Earnings Management: Evidence from Stock Options,” available here.

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