CEO Risk-Related Incentives and Income Smoothing

Executive Summary

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 a manager to make apparent risk lower while masking the underlying real risk. As such, income smoothing can be a means by which a manager 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 chief executive officer (CEO) share and option holdings. Additionally, we find that our results are especially pronounced in firms whose risk and risk-taking behavior are high.

From an agency perspective, a CEO who is employed by a company and whose compensation is heavily related to firm performance has an incentive to accept less risk than that accepted by diversified shareholders. On the one hand, risk-neutral shareholders like the CEO to undertake all positive net present value (NPV) projects; on the other hand, risk-averse managers are likely to avoid some risky but positive NPV projects. As a remedy, option compensation has been used as an instrument for motivating managers to accept more risk; prior studies have shown that CEOs respond to such risk-taking incentives embedded in compensation contracts.

Managers choose a particular level of risk that is based on a combination of firm-level, industry-level, and personal factors. However, not all forms of risk and ensuing volatility necessarily fit managerial and shareholder preferences. Consequently, the intrinsic costs of risk affect the numbers reported and, hence, may motivate managers to mitigate such effects through earnings management. Evidence from academia and industry indicate that both shareholders and managers attempt to reduce earnings and stock price volatility. Therefore, given risk-taking incentives and firm risk, income smoothing can be viewed as a mechanism used to avoid the undesirable consequences of risk on reported earnings, such as potentially large losses and wide fluctuations, and to preserve shareholder interests and institutional investor preferences. In this context, the role of managers and the underpinnings of their behavior can hardly be overestimated. Managerial compensation contracts provide information about risk-taking incentives, which in turn may shed light on financial reporting decisions. We investigate whether risk-related incentives of ESO compensation are associated with income smoothing. We predict, a priori, that they are positively related. Examining compensation contracts and their relationship to smoothing is especially productive because interested parties ex ante can fully observe compensation contracts. This is in contrast to investment decisions and CEO risk taking, which are only partially observable. Our purpose in examining compensation contracts is to understand and predict CEO financial reporting decisions given the risk-taking incentives embedded in executive compensation.

In the current study, we find strong evidence that risk-taking incentives are positively related to measures of income smoothing. These results are robust across various specifications of our income smoothing and risk-taking variables as well as various estimation techniques. This study may be of interest for several reasons. By examining income smoothing as it relates to CEO option risk incentives, it adds to prior research. Extant research has examined the role of earnings management in relation to both ESOs and bonus plans. However, beyond the existence of ESOs, the structures of the option contracts vary in ways that create differing incentives for executives to smooth income and/or manage earnings. This paper incorporates the option contract characteristics and their effects on financial reporting choices; it also contributes to the literature on managerial behavior. The incentive effects of compensation plans have been the focus of numerous examinations. As Indjejikian (1999, 150) observes, research has long sought to establish a relationship between risky pay and executive actions. We contribute to this research by showing that this risk-taking behavior is accompanied by financial reporting decisions that lead to smoother income streams. Furthermore, our study suggests that the relationship between risk-taking incentives and smoothing is particularly strong in firms with high idiosyncratic volatility. Given the large and growing literature on the pricing of earnings quality and information risk, we deem this finding to be especially topical. Finally, our study contributes to the recent work of Graham, Harvey, and Rajgopal (2005), who argue that because investors and analysts loathe uncertainty, managers are likely to forgo positive net present value (NPV) projects if they lead to increased volatility. We show that managers with the incentive to take risk are more likely to smooth income than their counterparts who do not, especially if risk-taking activity is high. In turn, we add to the literature on the determinants of smoothing behavior.

We measure CEO risk-related incentives of ESOs as the Vega (sensitivity of options to a unit change in volatility) divided by its Delta (sensitivity of options to a unit change in stock price), a methodology similar to that employed by Rogers 2002, 2005. We measure earnings smoothing as the correlation between changes in “managed earnings” and changes in “unmanaged earnings”; in other words, we measure the correlation of the change in discretionary accruals with the change in nondiscretionary income. We employ a simultaneous equations design in which the first equation estimates risk-taking incentives as a function of firm and CEO characteristics. The second equation examines the relationship between the risk-taking incentives and income smoothing. This statistical formulation is similar to that used in other recent studies examining CEO risk-taking incentives.

Using three-stage least squares, we find that risk-taking incentives are positively related to our income-smoothing measures. This relationship is robust to controlling for firm performance, growth opportunities, firm risk, institutional presence and sell-side analyst coverage, CEO ownership, and industry membership. This result is also robust for alternative specifications of income smoothing and risk-taking incentives, as well as for controlling for CEO option holdings and firm governance characteristics. The results are robust to alternative statistical methodologies. We also show that the relationship between risk-taking incentives and income smoothing is strongest in the presence of institutional investors, when risk taking is high, and in firms in which idiosyncratic volatility is high. Finally, the results using both a Granger 1969 analysis and a changes analysis indicate that risk-taking incentives are positively related to income smoothing.