CEO Stock Options Drive Income Smoothing

[A] new study finds that to a large extent, [any benefit from income “smoothing”] actually depends on the relative volume of stock and stock options held by the CEO.

Prior research has offered two competing explanations for corporate income smoothing, notes the study, “Managerial Equity Holdings and Income-Smoothing Behavior,” published in the spring issue of the American Accounting Association’s Journal of Management Accounting Research.

One is that managers use it to dampen the volatility of stock performance caused by their own opportunistic, risk-taking behavior.

The other, less nefarious explanation: a desire to help investors better predict future performance by reducing reported earnings volatility caused by transitory items.

The research found that granting stock to a CFO supports the second motivation, while option grants support the first.

Stock grants, the professors write, align managers’ actions with shareholders’ interests by linking their respective wealth. The relationship between past income smoothing and investors’ ability to predict future earnings increases with greater CEO stock holdings, they found.In contrast, option grants “offer a convex payoff structure where the value of the option to a manager relates positively to the volatility of the [stock price]. Managers, therefore, benefit proportionately more from engaging in risky actions,” says the paper, by Sydney Qing Shu of San Diego State University and Wayne B. Thomas of the University of Oklahoma.

Consistent with managers attempting to hide the excessive risk-taking activities that can lead to high volatility, the professors found, the relationship between income smoothing and future earnings predictability decreases with greater option holdings.

Source: CEO Stock Options Drive Income Smoothing

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