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EXECUTIVE STOCK OPTIONS, MISSED EARNINGS TARGETS AND EARNINGS MANAGEMENT: EVIDENCE FROM BOOK-TAX DIFFERENCES Mary Lea McAnally Anup Srivastava Connie D. Weaver July 7, 2006 Abstract: We examine whether managers with larger stock-option grants are more likely to miss earnings targets, and if so, whether earnings management is implicated. Anecdotal evidence and recent surveys suggest that managers believe that missing an earnings target can cause stock prices to slide sharply (Graham, et al. 2005). Thus, missing a target can reward executives via a lower strike price on option grants. To explore the relation among stock-option incentives, missed earnings targets and earnings management, we collect data for 1,744 firms for the years 1993 through 2004. We find that CEOs’ option grants increase in number and in dollar value when firms miss earnings targets by reporting small losses or small year-over-year earnings declines (Burgstahler and Dichev, 1997). We use book-tax differences to proxy for earnings management (Mills and Newberry 2001, Phillips et al. 2003) and our results suggest that firms manage earnings downward around CEO option-grant dates. Most importantly, we document that option grants create strong incentives for executives to miss earnings targets via downward earnings management. To the extent that missed targets precipitate larger negative price reactions (Skinner and Sloan 2002, Lopez and Rees 2002), they provide a greater increase in stock-option grant value than managing earnings at any other point in the earnings distribution. JEL Classification: G34, J33, M41, M52 Keywords: Book-tax differences; Earnings management; Stock options; Earnings benchmark Data Availability: All data used in this study are publicly available. The authors gratefully acknowledge written comments from: David Burgstahler, Ross Jennings, William Kinney, Lisa Koonce, Lillian Mills, John Phillips, Tom Omer, Steve Rock, Senyo Tse, Terry Warfield, and workshop participants at Brigham Young University, Colorado State University and University of Texas at Austin. We thank Professor John Graham for his marginal tax rate data. McAnally received funding from Mays Business School Summer Research Funding Program. Weaver and Srivastava received funding from Deloitte & Touche.
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EXECUTIVE STOCK OPTIONS, MISSED EARNINGS TARGETS AND EARNINGS MANAGEMENT: EVIDENCE FROM BOOK-TAX DIFFERENCES I. INTRODUCTION Theoretically, executive stock-options align managers’ and shareholders’ interests. Practically however, stock options may engender manager-shareholder conflicts (Jensen 2005) and create incentives for earnings management (e.g. Jensen, Murphy and Wruck 2004, Burns and Kedia 2005, Efendi et. al. 2006). Both conventional wisdom and prior empirical results suggest that grants ( exercises ) provide incentives to manage earnings downward ( upward ) (e.g. Balsam et al. 2003; Baker et al. 2003, Bartov and Mohanram 2004, Bergstresser and Philippon 2006,
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