Giving managers stock option grants aligns their interests with those of shareholders, at least according to conventional wisdom. Research has confirmed that this is usually true, but a new study shows that in some cases, CEOs purposely miss earnings targets to cause a drop in stock prices just before the time for stock option grants—an outcome clearly inconsistent with shareholders’ interests.

Managers have broad discretion about the reporting of earnings under generally accepted accounting principles, and they exercise this discretion in deciding when and what to report. Anup Srivastava (Donald P. Jacobs Scholar in Accounting Information and Management at the Kellogg School of Management) explains that managers are given discretion because rules cannot be created that anticipate all possible situations—it is expected that managers will use their discretion to provide information that is useful to investors. However, the new research provides evidence that this discretion is sometimes abused and “highlights a situation where CEOs might trade off firm value to enhance personal wealth,” Srivastava and his colleagues write in The Accounting Review.

Suspicious Evidence
The idea that missing an earnings target can result in a drop in a firm’s stock price is supported by both anecdotal and empirical evidence. Therefore, a missed earnings target could translate into a benefit for a firm manager by resulting in a lower strike price on subsequent option grants. In previous research, Srivastava showed an association between stock options and subsequent earnings misstatements. He says the new research “looks at the flip side—seeing whether there are instances where managers miss earnings targets before stock option grants.”

For firms that set aside a portion of earnings to bolster future statements—a practice known as managing earnings downward—the likelihood of missing targets increased with stock-option grants.

Srivastava teamed with Mary Lea McAnally (Professor of Accounting at Texas A&M University) and Connie D. Weaver (Associate Professor of Accounting at Texas A&M University) to examine whether option grants can encourage executives to miss their earnings targets. For the years 1992–2005, they gathered CEO compensation data for 1,724 firms in a broad cross-section of industries, then compared quarterly and yearly data for fixed-date grants with firms’ announcements that they had missed earnings targets. They found that firms that missed those goals had larger and more valuable subsequent grants. In addition, for firms that set aside a portion of earnings to bolster future statements, a practice known as managing earnings downward, the likelihood of missing targets increased with stock-option grants. “These results are robust across models where [the] missed earnings target is a loss, an earnings decline, or a missed analyst forecast,” the researchers report.

They explain that their sample included only firms considered likely to be managing earnings downward to control for the possibility that firms missed earnings targets for operational reasons. The researchers also controlled for “backdating,” a practice in which a firm sets a grant date that falls immediately after any adverse event. For backdating to occur, the date for granting the stock option must be flexible, and that was the rationale for including only firms that granted options around the same dates every year.

Rational? Yes. Legitimate? No.
“The behavior that we document could be irrational if it was repeated so often that the CEO might reasonably anticipate being caught and punished or if the CEO did not expect a stock-price rebound before he/she exercised options or sold stock,” the researchers acknowledge. Upon conducting further analyses, they found that the probability that firms would miss their quarterly earnings targets just before fixed-option grant dates was abnormally higher than the firms’ own time-series average (Figure 1). However, this abnormal difference reversed in the very next quarter after the fixed-date grants. Moreover, immediately following the fixed-grant dates, the probability of beating earnings targets increased significantly (Figure 2). The researchers control for factors such as CEO stock option exercises, CEO performance-linked bonuses, and firm proximity to default on debt covenants, all of which lower the probability of missing earnings targets. Taken together, the authors conclude, these results show that missing an earnings target can be a rational executive decision.

The authors do not equate “rational” with “legitimate,” of course. They note, “Missing an earnings target is particularly egregious because stock prices are likely to tumble—an outcome clearly inconsistent with shareholders’ interests.”

The finding that some managers abuse their discretion does not mean that stock options are a bad idea, Srivastava says. “We have documented certain behaviors that are aberrations. In general, stock options probably do align interests of shareholders and managers.” But, he added, during his more than fifteen years of experience working in industry when he was personally involved in creating incentive stock options for managers, “I saw that at times it led to deviant behavior.”

The researchers suggest that to improve detection of opportunistic manipulation, boards of directors should consider increasing their oversight of management following missed targets. Another option would be for compensation committees to restructure incentive contracts. For example, the contracts could include a high-water-mark provision that sets the strike price of each period’s option grants equal to the stock’s all-time high value or annual high value. The bottom line, Srivastava says, is that “compensation committees and shareholders need to be vigilant in observing the relationship between missed earnings targets and stock option grants.”