Relationship between Executive Stock Option Exercises and Earnings Management*

Abstract

In this study we examine whether executives manage accounting earnings to maximize their own gains around stock option exercises. In particular, this study analyzes the effects of two factors, the value of exercised executive stock options and the change in the value of exercised executive stock options for a 1% change in the underlying stock price on the propensity of managers to engage in earnings management. Furthermore, the present paper investigates whether the relations between both the value and the price incentive of exercised stock options and earnings management are more affected by the level of information asymmetry and the length of the stock disposition period after exercising stock options. The sample for this study consists of 93 observations from 51 companies listed on the Korea Stock Exchange and Korean Securities Dealers Automated Quotations. Managers exercised their stock options from the fourth quarter of 2002 to the fourth quarter of 2005. The empirical findings are as follows. First, higher values and price incentives for executive stock options were associated with higher earnings management. These results imply that executives manage firms’ reported earnings to maximize their own gains around stock option exercises. Second, information asymmetry reinforces the association between both the values and price incentives of exercised executive stock options and earnings management. Finally, the values and price incentives of exercised executive stock options provide greater incentives for executives to manage earnings when executives sell the acquired stocks after exercising the stock options.