Gaming Operating Performance: Managerial Incentives and the Impact of Discretionary Financial and Disclosure Decisions

Abstract

We extend the existing research on managerial incentives and operating performance measurement by integrating the market impact of the manager's discretionary financial and disclosures decisions to stock price performance in compensation contracts. There is evidence that managers manipulate accounting numbers to mitigate the consequences of decreasing operating performance and negative compensation effects. We argue that managers may also use discretionary financial decisions to meet market expectations and avoid compromising internal control systems. We focus on the financial decision to repurchase stock, given the prevalence and documented positive market impact of that activity. While controlling for other factors associated with stock repurchases, we examine the likelihood that firms with decreasing operating performance use stock repurchases to help meet analyst expectations to avoid stock price decreases. We find that managers that repurchase stock are also likely to benefit from higher stock prices, since they exercise more stock options in the year following the stock repurchase. We also examine whether firms that use stock repurchases use MD&A disclosures to manage expectations downward. We find that rather than managing expectations downward, managers are likely to provide more optimistic disclosures, especially when planning stock repurchases. Our results suggest that the current emphasis on stock price performance in management's compensation contracts may not eliminate managerial opportunism, given the market impact of the manager's discretionary financial and disclosures decisions.