CEO Risk-Related Incentives and Income Smoothing

We investigate whether risk-related incentives of executive stock option (ESO) compensation plans are associated with income smoothing. Given that risk has both potential benefits and costs, including possible losses and/or large fluctuations that affect reported financial outcomes, flexibilities in financial reporting enable managers to reduce apparent risk while masking the underlying real risk. Thus, income smoothing can be a means by which managers can reduce the unintended consequences of risk taking without at the same time reducing its intended consequences. Using a sample of approximately 7,000 firm-years, we find that risk-taking incentives and income smoothing are positively related. Our results are robust to alternative specifications of income smoothing and risk taking, and to various firm-level characteristics, including governance structures and CEO share and option holdings. We also find that our results are especially pronounced in firms whose risk and risk-taking behavior are high.