Executive Stock Options, Missed Earnings Targets, and Earnings Management

Abstract

This paper examines whether stock-option grants explain missed earnings targets, including reported losses, earnings declines, and missed analysts' forecasts. Anecdotal evidence and surveys suggest that managers believe that missing an earnings target can cause stock-price drops (Graham et al. 2006). Empirical studies corroborate this notion (Skinner and Sloan 2002; Lopez and Rees 2002). Thus, a missed target could benefit an executive via lower strike price on subsequent option grants. Prior option grant studies explore only general downward earnings management (Balsam et al. 2003; Baker et al. 2003), but our study is the first to explore whether option grants encourage missed earnings targets. Indeed, if missed targets drive the prior results, then the literature has failed to document an important negative outcome of stock-option incentives. We use quarterly and annual data for fixed-date options granted after firms announce they have missed earnings targets. We find that firms that miss earnings targets have larger and more valuable subsequent grants. Further, we find that the likelihood of missing earnings targets for firms that manage earnings downward increases with stock-option grants. To control for the possibility that firms miss earnings targets for operational reasons, we only include firms that likely managed earnings downward (Dechow et al. 1995; Phillips et al. 2003). Backdating or opportunistic timing of grants cannot explain our results because we include only fixed-date grants. While many studies explicitly consider whether and why managers meet or beat earnings targets, ours is the first study to find that some managers may seek to miss earnings targets (Burgstahler and Dichev 1997).