Executive Stock Options and Earnings Management: A Theoretical and Empirical Analysis

We study the effect of the grants of executive stock options (ESOs) and restricted stock on earnings management and insider trading during the vesting years of these grants. In our theoretical model, an informed manager compensated by stock options is mandated to issue an earnings report. Uninformed investors price the stock based on this report. The manager can manipulate the report to affect the stock price, but earnings management is costly to the manager. The optimal report balances the benefits from exercising stock options and the costs of earnings management. Earnings management and insider trading occur at the vesting date only if the options are in the money post manipulation, and are intensified by larger grants. The model identifies three major determinants of the extent of both earnings management and insider trading: The moneyness of the options at the vesting date, the size of the grants, and cumulative stock returns between the grant date and the vesting date. Our empirical results confirm that the moneyness of newly granted stock options and cumulative stock returns are strongly correlated with both earnings management and insider trading in vesting years. In contrast, the size of the grants is only weakly related to earnings management and insider trading in vesting years.