Equity Incentives and Earnings Management by Cheng

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Table of Contents

Introduction
Hypothesis development
Sample and data
Empirical results
Additional analysis
Conclusion and implications

Introduction

One of the important aspects of defining the implications of earnings management concerns the association between stock-based compensations of managers, their equity rates and the degree to which earnings are managed. In such a way, stock ownerships can affect directly or indirectly the compensation and benefits of a manager, which is why such a situation creates certain incentives that induce earnings management.

Naturally, in the modern business context, there are several various mechanisms and techniques aimed at controlling and remedying such processes. They include a hypothetical linkage between stock prices and managerial ownership, as well as stock-based compensations, to the interests of managers in the companys performance, and therefore, benefits not only for the executives but also for all stakeholders.

However, there is also a strongly supported possibility that, in such a scenario, managers will only pay attention to the stock prices and the companys performance on a short-term basis, which is why they will gain the majority of their benefits while they are managing a particular company. Moreover, the easiest way to achieve such a short-term increase in the companys performance and the price of stocks includes the elements of earnings management. Because the current earnings of the company will be managed and will appear higher than its actual performance is, it will also harm the overall performance of the company in the long run because the future analysts predictions about it will be made on the basis of currently managed earnings.

Hypothesis development

One of the patterns observed in managers behavior is that executives with higher equity rates are more likely to sell their stocks after they finish their contracts. For that reason, the main hypothesis is that there is a direct linkage between the effects of the managerial actions to improve the companys performance solely on a short-term basis and earnings management incentives. One of the motivations of managers, in such a situation, is, of course, the fact that managers are looking for a personal benefit, in the first place, affects their decisions concerning earnings management.

Executives operate a variety of different elements that relate to their stock-based compensations and equity rates. Those forms of holdings include various options for managing stock grants and types of ownership. Therefore, there is a theoretical relationship between equity incentives, including all the options from exercisable ones to the stock ownership, the earnings management in terms of the need to meet analysts expectations, and the future selling of the stocks. In such a way, another hypothesis is that occurrence of earnings management is related to equity incentives.

In the ideal business environment maintained in a particular company, there should be an equilibrium among those three aspects. However, the dominance of two of them is likely to result in higher levels of earnings management and a decline in the companys performance in the long run.

Sample and data

For the study, Chang and Warfield used the data collected from the financial documents related to the stock-based compensations and their implications and effects on the companies long-term performance. The included data was obtained from the Execu-Comp databases, and it concerned the provided data from the 1993 2000.

Empirical results

Given the scope of Chang and Warfields study and the developed hypothesis, the results suggested that stock ownership and stock-based compensations for managers as a part of the equity model can create specific incentives for earnings management. The primary empirical results concerned the analysis of equity-related incentives and future selling of the managers stocks, based on comparing the rates of option grants, unexercisable options, exercisable options, cash flow, the companys size and growth, and the level of stock returns. The results were also analyzed in the sphere of correlations between the earnings management and the levels of various options for the managerial equity-based compensation, as well as the linkage between the degree to which earnings management is incorporated in the companys daily operation and the number of stocks that managers trade after they leave the company.

Additional analysis

In addition to the initial results of the study, it is also important to point out the fact that the additional analysis in the study revealed a correlation between analysts expectations, earnings management incentives, and the possibility of trading the stocks by managers. In particular, boosting the companys performance by managing both real earnings, such as cash flow, and financial accruals of different kinds can result in managers gaining more profit using selling stocks and shares after they registered the earnings in financial reporting in such a way that they would largely exceed analysts expectations. On the other hand, there is another scenario including trading their stocks after they managed the abnormal accruals that would boost the income.

Conclusion and implications

Overall, high equity incentives create for the executives some motivation to exercise earnings smoothing because of the possibility of personal benefits via trading stocks in the future. Moreover, there is also a relationship between analysts forecasts and managers desire to boost the companys performance by means of earnings management.

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Equity Incentives and Earnings Management by Cheng

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