Rank and file equity compensation and earnings management: Evidence from stock options

• Date: 01 October 2019
• Published date: 01 October 2019
• Author: D. Kip Holderness,Adrienna Huffman,Melissa Lewis‐Western
• DOI: http://doi.org/10.1111/jbfa.12404

DOI: 10.1111/jbfa.12404

Rank and file equity compensation and earnings

management: Evidence from stock options

D. Kip Holderness Jr.1AdriennaHuffman2

Melissa Lewis-Western3

1WestVirginia University, West Virginia, USA

2The BrattleGroup, California, USA

3Brigham YoungUniversity, Utah, USA

Correspondence

MelissaLewis-Western, Brigham Young

University,Utah, USA.

Email:melissa.western@byu.edu

Fundinginformation

Institutefor Fraud Prevention; Association of

CertifiedFraud Examiners

Abstract

The widespread use of rank and file equity-based compensation sug-

gests that executivesbelieve that rank and file employees can affect

firmoutcomes, and some research supports this view. If equity-based

incentives influence rank and file employees’ productive efforts,

they might also influence their earnings management decisions.

We find that increases in rank and file employees’ option-based

compensation—our proxy for equity-based compensation—are

associated with increases in earnings management and that this

relation is attributable to real activities (as opposed to accrual) earn-

ings management. Cross-sectional tests indicate that the relation is

stronger when rank and file option compensation is likely to gener-

ate greater performance incentives and attenuated in the presence

of more intense monitoring. Finally, we explore the role of cash

constraints and overvaluation as potential alternative explanations

for this relation and find that neither accounts for our results.

KEYWORDS

accrual-based earnings management, earnings management, earn-

ings quality, equity compensation, equity incentives, financial

reporting quality, fraud, rank and file employees, real earnings

management, stock options

1INTRODUCTION

The widespread use of rank and file equity-based compensation (hereafter,equity compensation) suggests that exec-

utives believe that rank and file employees can affect firm outcomes.1In support of this view,research provides evi-

dence that rank and file equity compensation leads to improved firm performance (Hochberg & Lindsey, 2010) and

influences the riskiness of projects chosen by employees (Bova, Kolev,Thomas, & Zhang, 2015). One negative conse-

quence, however,of equity compensation is that it can create economic incentives for earnings management and prior

research provides evidence of this consequence for executives (e.g.,Armstrong, Larcker, Ormazabal, & Taylor,2013;

1Rankand file employees are non-executive and non-senior-level-management employees of a company (see, for example, BusinessDictionary.com).

J Bus Fin Acc. 2019;46:1201–1236. wileyonlinelibrary.com/journal/jbfa c

2019 John Wiley & Sons Ltd 1201

1202 HOLDERNESS ET AL.

Bergstresser & Philippon, 2006; Burns & Kedia, 2006; Cheng & Warfield,2005; Efendi, Srivastava, & Swanson, 2007).

Rank and file employees, however, differ from executives on dimensions that likely influence the relation between

equity compensation and earnings management. Consequently, results from studies exploring the influence of exec-

utives’ equity compensation on earnings management may not generalize to rankand file employees. In the context of

rank and file employees’ equity compensation, Call, Kedia, and Rajgopal (2016) find that rank and file equity awards

are increased during periods of fraud perpetration, which may signal an attempt by executivesto discourage whistle-

blowing or even encourage the facilitation of fraud.The aim of our study is to build on the work of Call et al. (2016) by

providing evidence on the general relationship between rankand file equity compensation and earnings management

(i.e., in non-fraud contexts), and by exploringif any documented effect stems from accrual- or real-activities earnings

management.

This evidence is important because there are reasons why rank and file employees’ equity compensation may not

influence the firm’s earnings management strategies generally. Forinstance, in contrast to executives whose actions

often swiftly impact the firm’s stock price, rank and file employees may not believe that their efforts can influence

the firm’s stock price. Indeed, Oyer (2004) refers to rank and file equity compensation as “incentives” that have no

incentiveeffects. In addition, rank and file employees may lack the ability or opportunity to influence the firm’s earnings

management decisions, even if theyhave incentives to do so (Bova et al., 2015).

Toprovide evidence on the relation between rank and file equity compensation and earnings management, we focus

on one form of equity compensation: stock options. We do so because we are able to infer rank and file stock option

grants for a large sample of firms, but we are unable to construct such measures for other forms of equity compensa-

tion.2Tothe extent that the incentives created by stock options differ from other forms of equity compensation (see

Irving,Landsman, & Lindsey, 2011, for example), the generalizability of our results is limited to rankand file stock option

compensation. FollowingCall et al. (2016), we measure rank and file stock options with total outstanding stock options

as of the end of the year. Wealso separate total outstanding stock options into current year grants and beginning of

year outstanding stock options to investigateif any documented effect varies with current versus outstanding grants.

Because earnings can be managed using both accruals and real activities, we examine both types of earnings man-

agement in our analyses. Tomeasure accruals-based earnings management, we calculate abnormal revenue following

Stubben (2010). Toidentify real activities earnings management, we measure two strategies: (1) granting excessively

lenient credit terms which produces lower than normal cash flows given the levelof sales, and (2) overproducing inven-

tory,which lowers the per unit cost of goods sold (Cohen & Zarowin, 2010; Roychowdhury, 2006).

Westudy the influence of rank and file stock option compensation on earnings management using a sample of 9,508

firm-years from 2004–2016. Toensure appropriate conclusions, we include controls in our models for factors related

to firms’ decisions to grant rank and file options, factors known to influence measures of earnings management, vari-

ables reflecting executives’ economic incentives, and year and firm fixed effects. We find that rankand file options

are significantly and positively associated with earnings management. Further analyses suggest that this increase is

attributable to real activities earnings management and that the finding is robust to an instrumental variable approach.

Overall, our results provide evidence of a positive relation between rank and file options and earnings manage-

ment. Sloan (2016), however,identifies two alternative explanations that might confound conclusions from our study.

First, Sloan (2016) posits that cash-constrained firms may be more likely to manage earnings and more likelyto grant

option compensation to employees. Second, Sloan (2016) providesa possible overvaluation explanation in which firms

manage earnings to artificially inflate stock price and then subsequently utilize option compensation, which due to the

overvaluation of equity,is relatively cheap. In additional analyses, we examine these predictions and find that they do

not account for our results. Also, these analyses provide some evidence that cash constraints influence current-year

option grants, but very limited evidencein support of the overvaluation explanation.

2For example, we can obtain data on executives’restricted stock grants, but we are unable to infer the portion attributable to rank and file employees, as

a summary measure of the firm’s total restricted stock grants is unavailable from ExecuComp or Compustat. We are able to obtain data on rankand file

ownershipin the company’s stock via retirement plans (e.g., 401(k), pension and deferred profit-sharing plans). We discuss these analyses in section 4.5.

HOLDERNESS ET AL.1203

We also conduct two cross-sectional analyses that examine if our results our stronger for firms where rankand file

option compensation is likely to generate greater performance incentivesand attenuated for firms with more intense

monitoring. First, Hochberg and Lindsey (2010) find that the incentive effect of rank and file option compensation is

greater for firms with fewer employees where free riding concerns are reduced and mutual monitoring effects are

amplified. We find that the association between rank and file options and earnings management is stronger for firms

with fewer employees.Second, we examine whether our results are attenuated for firms with more intense monitoring

of employees. Prior research suggests that superior monitoring by independent boards constrains earnings manage-

ment (e.g., Beasley,1996; Cornett, Marcus, & Tehranian, 2008; Klein, 2002). Consistent with this notion, we find that

the relation between rank and file options and earnings management is attenuated for firms with superior monitoring

as measured by board of director independence.

Our paper contributes to two streams of literature. First, our results provide evidence of the general relationship

between rank and file option-based compensation and earnings management, which extends Call et al. (2016) who

document this relation within the context of fraud. Our results add insight bydocumenting that the effect of rank and

file option compensation primarily manifests via real activities earnings management and is not attributable to cash

constraints and overvaluation. Second, our results contribute to the emerging literature documenting an influence of

rank and file employees on firm outcomes (Bovaet al., 2015; Call et al., 2016; Call, Campbell, Dhaliwal, & Moon, 2017;

Hochberg & Lindsey,2010; Kim & Ouimet, 2014; Ouyang & Sallehu, 2015; Oyer, 2004; Oyer & Schaefer,2005).

While we take several steps to calibrate our conclusions, a few caveatsremain. First, we are unable to determine

if the increase in earnings management we document stems solely from the incentives created by rank and file option

compensation or if these incentives work in conjunction with other changes accompanying rank and file option com-

pensation(e.g., aggressive internal budget targets set by management). We leave such identification for future research

as the answer will likely require non-archival methods. We also note that our results do not speak to the optimality of

rank and file options as the associated incremental earnings management may be more than offset bygreater produc-

tive efforts incentivized by option compensation and may even be anticipated exante. Finally, we motivate our tests

from the perspectivethat rank and file option compensation will motivate changes in rank and file employees’ behavior,

but we cannot separate executive-drivenearnings management from earnings management initiated by rank and file

employees. As such, our results only document changes in earnings management, but cannot identify with surety the

source of those changes.

2HYPOTHESIS DEVELOPMENT AND RELATED RESEARCH

2.1 Earnings management

Following Healy and Wahlen(1999, p. 368), we define earnings management as occurring when employees “use judg-

ments in financial reporting and in structuring transactions to alter financial reports to either mislead some stakehold-

ers about the underlying economic performance of the company or to influence contractual outcomes that depend on

reported accounting numbers.” A substantial amount of research investigates earnings management and we refer the

interested reader to Dechow, Ge, and Schrand(2010) for a review.

2.2 Rank and file equity compensation plans

The use of equity compensation has increased substantially over the past few decades (Hall & Murphy,2003; Murphy,

2012; Revsine, Collins, Johnson, & Mittelstaedt, 2012), and the majority of equity awards are granted to employees

who are not among the firms’ five most highly compensated executives(Hall & Murphy, 2003; Murphy, 2012; Ouyang

& Sallehu, 2015). Firms use rank and file equity compensation to align employee effort with shareholder objectives

(Conyon& Murphy, 2000), to attract and retain entrepreneurial employees (Core& Guay, 2001; Oyer & Schafer,2005),