Asia-Pacic Journal of Financial Studies (2012) 41, 241257

doi:10.1111/j.2041-6156.2012.01072.x

Earnings Manipulation, Corporate Governance and Executive Stock Option Grants: Evidence from Taiwan*
Ming-Cheng Wu**
Department of Business Education, National Changhua University of Education

Yi-Ting Huang
Department of Money and Banking, National Chengchi University

Yi-Jing Chen
Department of Business Education, National Changhua University of Education Received 31 August 2011; Accepted 11 January 2012

Abstract
Executive stock options (ESOs), serving as a compensation mechanism, are widely used in business administration. ESOs link managerial wealth to rm performance and shareholder wealth. The intrinsic value of ESOs is determined by the difference between the stock price and the strike price. Executives, as a result of self-interested incentives, would therefore manipulate rms reported earnings for inuencing stock prices. Such conduct may boost the value of ESOs and then benet managers greatly. This study attempts to explore if earnings had been manipulated before the ESO award date to satisfy some self-interested managers. In addition, the paper attempts to reveal the cause and effect relationship between executive incentives and earnings management when compensations are linked to stock prices. The empirical results show that there is a signicant downward earnings management phenomenon before the ESO award date. Furthermore, quarterly earnings management occurs frequently around the ESO grant date. Keywords Executive stock option; Earnings manipulation; Incentives; Compensation JEL Classication: G34, M12, M52

*Acknowledgements: We thank two anonymous referees and Jun-koo Kang (Editor) for their helpful comments. **Corresponding author: Ming-Cheng Wu, Department of Business Education, National Changhua University of Education, No. 1, Jin-De Road, Changhua 500, Taiwan. Tel: +8864-7232105 ext 7321, Fax: +886-4-7211290, email: mcwu@cc.ncue.edu.tw.
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1. Introduction Incentive compensation contracts, provided for top managers, have been considered a good solution for reducing the agency problem between managers and shareholders owing to the link between CEO compensation and rm performance. Some practitioners and researchers have recently challenged this viewpoint; they claim that even though compensation contracts may be conducive to aligning the interests of managers and shareholders to some extent, they nevertheless create a set of new agency problems (Bebchuk and Fried, 2003). Executive stock options (ESOs) can provide managers with incentives and hence mitigate the agency problem between managers and shareholders because the most crucial function of ESOs is to directly link executive compensation with the rms performance. This compensation scheme ensures that incentivized executives appear commit themselves to maximizing the rms share price because the results will have a direct personal benet. However, this linkage can mean that some executives manipulate the rms share price for lower a ESO exercise price to increase the intrinsic value of ESOs. So, executives prefer the stock price to be as low as possible. There are several ways to manipulate ESO exercise price: accelerate bad news and delay good news announcements before ESO grants (Yermack, 1997; Aboody and Kasznik, 2000); earnings management (Cheng and Wareld, 2005; Bergstresser and Philippon, 2006; Cornett et al., 2008); or backdating,1 which was rst proposed by Lie (2005). In this study, we focus on the relation between executive equity-based compensation incentives and earnings management. Byun et al. (2011) show that the value implications of nancing, investment, dividend, and cash-holding decisions are strong for rms with sound corporate governance practices. Furthermore, Cornett et al. (2008) point out that the apparent impact of governance structure and incentive-based compensation on rm performance stands up when measured performance is adjusted for the effects of earnings management. Beaver et al. (1980), and Hall and Liebman (1998) discover that stock prices tend to be positively related to earnings information. Hall and Liebman (1998) identify that if executives hold large option packages, the incentives of manipulating the report tend to be strengthened. The value of ESOs depends upon the difference between the stock price and the strike price. It is taken for granted that executives prefer stock prices to be as low as possible on the grant date to boost the intrinsic value of ESOs. The value of stock and option holdings has a strong bearing on a CEOs potential total compensation at rms where the manipulation of reported earnings appears to be carried out (Bergstresser and Philippon, 2006). In other words, accruals are deliberately managed more notably at rms
1

Lie (2005) denes backdating is an alternative type of ESO award that does not require the ability to forecast future stock price movements. Backdating means to set as the exercise date a past date on which the market price was particularly low.
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where equity-based compensation is granted. Some CEOs, holding stock-based compensation, are inclined to aggressively manipulate the rms nancial reports by using discretionary accruals (DA) for procuring a lower stock price for lower exercise price. Some executives, who are also members of the board of directors, are still entitled to receive ESO grants. In Taiwan, top executives such as CEOs generally belong to the compensation committee or board of directors. Hence, executives are incentivized to grant ESOs to themselves, seizing the opportunity to award large numbers of stock options, and managing earnings intentionally to affect the stock price in order to deate the exercise price of stock options. In this study, we focus our sample on IT industry rms listed on the Taiwan Stock Exchange (TWSE). Over 90% of rms that have issued ESOs are in the IT industry (see Table 1). According to the Economist Intelligence Units (EIU) IT industry competitiveness index, Taiwan ranks sixth globally and rst in IT labour productivity total output per employee.

Table 1 ESOs issued by rms that listed on Taiwan Stock Exchange (TWSE) and GreTai Securities Market. Unit: 10 000 shares IT industry all industries Total Number shares of grants granted (%) (%) 100.00 90.57 97.66 62.87 99.68 80.00 85.50 100.00 92.58 94.02 99.48 100.00 96.88 95.64 89.01

Item

IT industry

All industries

Year

Total Number shares of grants granted

Total Number shares of grants granted 14 69 96 71 24 27 301 10 59 111 45 39 22 286 587

Firms listed on Taiwan Securities Exchange 2001 14 5148.30 2002 63 8483.01 2003 94 16216.92 2004 43 10536.80 2005 23 5675.09 2006 25 3676.60 Total 262 49736.73 Fimrs listed on GreTai Securities Market 2001 10 2439.20 2002 54 5145.83 2003 103 13676.60 2004 44 3795.40 2005 39 3119.68 2006 21 1225.45 Total 271 29402.16 Listed on TWSE and 533 79138.89 GreTai Securities Market

5148.30 100.00 9366.11 91.30 16605.42 97.92 16760.59 60.56 5693.59 95.83 4595.40 92.59 58169.42 87.04 2439.20 100.00 5558.14 91.53 14546.75 92.79 3815.40 97.78 3119.68 100.00 1264.95 95.45 30744.12 94.76 88913.54 90.80

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In Taiwan, the exercise price is equal to the closing price on the grant date. This implies that managers may engage in a higher level of manipulating the DA before the grant date to achieve the goal of a downward trend in the earnings report. Namely, the stock price appears to descend prior to the grant date; accordingly, managers seem likely to take the lower stock price as the exercise price, which may consequently inate the intrinsic value of ESOs. This study examines whether there are differences in using accruals between the current quarter (the quarter that awards ESOs to executives) and previous quarters, and if differences are observable, whether the phenomenon has resulted from the managers self-interested behavior and whether it is related to the number of options granted, stock and ESOs executives hold. There are few existing discussions examining the relation between CEO stock-based incentives and earnings manipulation in quarterly nancial reports. Further, we are interested in the relation between the CEO stock options incentive and earnings manipulation before stock options grant date. When managers hold stock-based compensation, earnings management should be assessed to ascertain whether the high-level use of DA is subject to manipulation or not. In this study, we present some useful information and provide empirical results that could be helpful for investors and designers of CEO compensation structures. Our main results show that the absolute value of DA is signicantly positively related to CEO stock options incentive, which implies that there is a positive relation between CEO stock options incentive and earnings management. Further, there is a negative relation between CEO stock options incentive and DA. As a result, earnings management is downward manipulated which could slash the stock price on the grant date, in order to achieve a lower exercise price. This paper is organized as follows. In section 2, we briey discuss the literature and present our hypotheses. In section 3, we present our sample selection and methodology. In section 4, we show the results. The nal section offers our conclusions. 2. Literature Review and Hypotheses 2.1. Earnings Management Accruals are identied as the remainder of cash ows deducted from net income. In other words, net income is tantamount to cash ows from operations plus accruals. If managers focus their attention on reported earnings, they may put themselves in jeopardy, so accruals play an active role in earnings management. Accruals can be divided into two components: nondiscretionary accruals (NDA) and DA. Shipper (1989) points out that earnings management in the nancial report is premeditatedly exploited for cheating credulous outsiders in an attempt to earn individual prot. Earnings management takes place when managers, by exerting their inuence on nancial reporting and transactions structure, attempt to tamper
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with nancial reports not only to deceive stakeholders into believing in the distorted performance of the company but also to affect contractual outcomes that depend on reported accounting gures (Healy and Wahlen, 1999). 2.2. Adjustment of DA Healy (1985) substantiates the nonlinear relation between managers accruals policies and inherent incentives embedded in contracts. Moreover, he develops the hypothesis that some managers are incentivized to take advantage of DA to aggrandize their pocket. Total accruals (TA) include DA and NDA. The calculation of TA is as follows: TAt DEPt XIt D1 DARt DINVt DAPt fDTPt Dt g D2 1

where DEPt denotes deprecation in year t, XIt denotes extraordinary items in year t, DARt denotes accounts receivable in year t less accounts receivable in year t 1, DINVt denotes inventory in year t less inventory in year t 1, DAPt denotes accounts payable in year t less accounts payable in year t 1, DTPt denotes income taxes payable in year t less income taxes payable in year t 1, DEFt denotes deferred income tax expense (credit) for year t, D1 is a dummy variable that equals 1 if bonus plan earnings are dened after extraordinary items, D2 is a dummy variable that equals 1 if bonus plan earnings are dened after income taxes. Jones (1991) develops a model to calculate TA and relaxes the assumption that NDA are constant: TAJ i;t DCAi;t DCLi;t DCashi;t DSTDi;t Depi;t =Ai;t 1 To estimate TA the following model is used: TAJ i;t a0 a1 1=Ai;t 1 a2 DREVi;t a3 PPEi;t ei;t 3 2

where TAJ i;t is total accruals of rm i at time t, D is an operator that represents a one year change in the variable, DCAi,t denotes change in the current assets of rm i at year t, DCLi,t denotes changes in the current liabilities of rm i at year t, DCashi,t is the change in cash holding of rm i at year t, DSTDi,t is the change in long-term debt in current liabilities of rm i at year t, Depi,t is the depreciation and amortization expense of rm i at year t, Ai,t1 denotes total assets of rm i at year t 1, DREVi,t is the change in sales (scaled by lagged assets) of rm i at year t, PPEi,t is gross property plant and equipment (scaled by lagged assets) of rm i at year t. For constructing NDA, the estimated coefcients are used according to the following equation: NDAJ a0 ^ a1 1=Ai;t 1 ^ a2 DREVi;t ^ a3 PPEi;t i;t ^ 4

DA for the Jones model are calculated as the difference between TA and NDA, which are shown as follows:

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J DAJ i;t TAi;t NDAi;t

For the measurement of DA, Dechow and Sloan (1995) perform an evaluation of ve models: the Healy model, the DeAngelo (1986) model, the Jones model, the modied Jones model, and the Industry model, and compare the specications generated by these models across DA to assess which one is the ttest. The results suggest that the modied Jones model is the best for testing earnings management: ^ ^ ^ ^ NDAMJ i;t b0 b1 1=Ai;t 1 b2 DREVi;t DRECi;t b3 PPEi;t 6

where DRECi,t denotes the change in receivables (scaled by lagged assets) of rm i at year t. 2.3. CEO Compensation and Earnings Management Mehran (1995) nds that rm performance is positively related to the share of equity held by managers and executive compensation that is equity-based. Bergstresser and Philippon (2006) use a broader set of measures of insider trading, as well as data on option exercise. They nd that the use of DA to manipulate reported earnings is more pronounced at rms where the CEOs potential total compensation is more closely tied to the value of stock and option holdings. On Bergstresser and Philippons model, the DA is calculated via the modied Jones model. The strong relation between CEO compensation and the value of the stock may beget the active use of accruals. 2.4. Manipulation of Exercise Price for Enhancing CEO Compensation Yermack (1997) discovers that signicant positive abnormal stock returns occur during a period of approximately 50 days after the option grant date. In addition, after examining the timing of option grants and the date of earnings announcement, he reveals that CEOs prefer to receive options shortly prior to the disclosure of favorable earnings news that may subsequently be conducive to a higher stock price. It may be no coincidence that options are received directly before the announcement of examining a sample of good news. Yermack (1997) interprets the results as evidence that CEOs inuence the terms of their own compensation, in particular the timing of their ESO grants. Aboody and Kasznik (2000) indicate that some CEOs deliberately time their voluntary disclosures around option grant dates. Even if granted options on a xed schedule, by releasing bad news ahead of the grant date or deferring good news subsequent to the grant date, CEOs are still in a position to manage the timing of corporate news disclosures around predictable stock options grants. That is to say, postponed good news and advanced bad news may contribute to the sagging stock price on the grant date and subsequently enhance the value of ESOs. The closing price on the grant date determines the exercise price. A lower exercise price implies a higher premium that comes from the difference between the exercise price and the market price when the option contract is exercised. For some
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managers holding ESOs, the exploitation of the earnings management accordingly leads to the stock price falling on the grant date so that a lower exercise price is attainable and a higher value of ESO is achievable in the future. Following Bergstresser and Philippon (2006), the absolute value of DA is taken as the proxy for examining the earnings management in this study. The examination, focused on the previous quarters and current quarter, may unveil the phenomenon of accruals manipulation. In light of the previous argument, we propose the following hypotheses: H1: The discretionary accruals could be managed with increasing frequency in the quarterly report that is close to the grant date. Namely, the closer the grant date the more obvious the phenomenon of earnings management. H2: More ESOs held by executives may give executives the incentive to use higher discretionary levels in the nancial report. H3: When executives hold stock, they may aggressively use discretionary accruals in the nancial report. H4: If the rm grants large ESOs to executives this may result in the discretionary accruals being actively used. 3. Sample Selection, Variables and Model

3.1. Sample Selection We collect our sample from 2001 to 2006 for rms listed on the TWSE and GreTai Securities Market that have issued ESOs. We collect ESOs grant data from the market observation post system (MOPS) and nancial data from Taiwan Economic Journal Database (TEJDB). We exclude rms that have insufcient nancial data; the sample therefore consists of 349 individual grants. Approximately 90% of the rms that undertake ESO grants come from the IT industry (see Table 1). In other industries, the number of rms granting stock options is less than 30 each year. Accordingly, in this study, we devote our attention to the IT industry. The nal sample consists of 223 individual grants after excluding the rms that have insufcient compensation data. 3.2. Variables 3.2.1. Measuring Earnings Management. To examine the correlation between CEO compensation and earnings management, we dene the variables of earnings management as follows. Following Dechow and Sloan (1995), we calculate TA as the difference between earnings and cash ows from operations: Accruals can be divided into two components: NDA and discretionary accruals (DA). The former is an obligatory expense that has yet to be realized but is already recorded in the account books; the latter, a non-obligatory expense, tends to be
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utilized to manage earnings. NDA are dened as the tted values of the model and DA correspond to the residuals. We follow Kothari et al. (2005), adding return on assests (ROA) as a control variable to cushion the effect of manipulating DA. The previous eight quarters of ESO grant dates are employed as the estimated period. In addition, the ROA is added in DA and NDA as follows: TAi;t DCAi;t DCLi;t DCashi;t DSTDi;t Depi;t =Ai;t 1 7 TAK i;t b0 b1 1=Ai;t 1 b2 DREVi;t b3 DPPEi;t b4 ROAi;t ei;t ^ ^ ^ ^ NDAK i;t b0 b1 1=Ai;t 1 b2 DREVi;t DRECi;t b3 PPEi;t ^ ROAi;t b
4 K DAK i;t TAi;t NDAi;t

9 10

where D is an operator representing a one-quarter change in the variable; ROAi,t denotes return on assets of rm i at year t. 3.2.2. Measuring CEO Incentives. This study examines the relation between earnings manipulation and CEO equitybased incentives. We utilize Bergstresser and Philippons (2006) calculation of CEO equity-based incentive and further divide CEO equity-based incentive into two parts: CEO stock options incentive and CEO stock incentive to capture CEO incentive. When a manager holds stock and ESOs separately, there are different incentive effects regarding the change in companys stock price. In this study, the quarterly data is used to capture short-term earnings management. An executive is dened as being in the position of a president, vice president, associated vice-president, general manager, department general manager, executive chairman, vice executive chairman, or assistant manager. The measurement of CEO incentives from ESOs and stock respectively is expressed as follows. ONEPCTiO ;t 0:01 PRICEi;t OPTIONSi;t ONEPCTiS ;t 0:01 PRICEi;t SHARESi;t 11 12

where PRICEi,t is the share price of rm i at time t, SHARESi,t is the number of shares held by the manager, and OPTIONSi,t is the number of options held by the manager. This paper utilizes the same CEO incentive calculation as that used by Bergstresser and Philippon (2006), ONEPCT O , to calculate the variable INCEN_O. This measure of incentives is normalized in a way that captures the share of a
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hypothetical CEOs ESOs that would come from a one-percentage point increase in the value of the equity of the company; and use ONEPCT S to calculate the variable INCEN_S. This measure of incentives is normalized in a way that captures the share of a hypothetical CEOs value of holding stock that would come from a onepercentage point increase in the value of the equity of the company, as below:
O S INCEN Oi;t ONEPCTiO ;t =ONEPCTi;t ONEPCTi;t SALARYi;t BONUSi;t

13
O S INCEN Si;t ONEPCTiS ;t =ONEPCTi;t ONEPCTi;t SALARYi;t BONUSi;t

14 3.3. The Model For examining our hypotheses, we measure the DA via the detecting model of Dechow and Sloan (1995) and further add ROA as a control variable to calculate all quarterly DA in each sample rm. 3.3.1. Regression Model. First, we use the absolute value of DA to measure earnings management levels:   DAi;t  a0 a1 INCEN Oi;t 1 a2 INCEN Si;t 1 a3 Log Oi;t 1 a4 MTBi;t 1 a5 LEVi;t 1 a6 VOEGi;t 1 a7 Q2 a8 Q3 a9 Q4 ei;t Then, we use the DA to measure the direction of earnings management: DAi;t a0 a1 INCEN Oi;t 1 a2 INCEN Si;t 1 a3 Log Oi;t 1 a4 MTBi;t 1 a5 LEVi;t 1 a6 VOEGi;t 1 a7 Q2 a8 Q3 a9 Q4 ei;t 16 15

where DAi,t is the discretionary accruals of rm i at time t, INCEN_Oi,t)1 is the dollar change in the value of manager ESOs holding coming from a 1% increase in the rms stock price of rm i at time t 1, INCEN_Si,t1 is the dollar change in the value of manager stock holding coming from a 1% increase in the rms stock price of rm i at time t 1, Log_Oi,t)1 is log of total volume of grant of rm i at time t 1, MTBi,t)1 is the market to book ratio of rm i at time t )1; LEVi,t1 is the debt ratio of rm i at time t 1, VOEGi,t)1 is the change in net income of rm i at time t 1, Q2 is a dummy variable that equals 1 for the second quarter, and 0 otherwise, Q3 is a dummy variable that equals 1 for the third quarter, and 0 otherwise, Q4 is a dummy variable that equals 1 for the fourth quarter, and 0 otherwise. 4. Results

4.1. Descriptive Statistics Table 1 presents the ESOs issued by the listed rms on the TWSE and GreTai Securities Market, showing the contrast in number between the IT industry and all other
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industries from 2001 to 2006. There are 301 grants and over 0.5 billion shares granted in TWSE listing rms; 286 grants and over 0.3 billion shares granted in listing rms on the GreTai Securities Market. When it comes to the IT industry, the numbers of grants account for 90.8% and the granted shares take up 89.01% across all industries. The IT industry accounts for the largest proportion of ESOs issued, approximately nine in ten. The other industries, by comparison, issue fewer ESOs. That is, the calculation of DA based on other industries by the regression model is of no feasibility, which is the reason why other industries are completely ruled out in this study. Table 2 shows the descriptive statistics of using accruals in the current quarter and previous quarters of those rms that have granted ESOs. The mean value of absolute value of TA of each quarter is about 0.05. Figure 1 illustrates the DA, including the absolute value of total accruals (|TA|), absolute value of |DA| and DA.We nd the absolute value of TA is smooth. Furthermore, DA are also smooth on the previous three quarters, but they have a downward inclination on the previous quarter of ESO grant date, which implies that there is a downward earnings manipulation. The empirical results reveal that quarterly activities associated with earnings manipulation increase around the grant date. It should be noted that the reported earnings appear to be articially

Table 2 Accruals in the current quarter and previous quarter on option grant date
|TA| is the absolute value of total discretionary accruals (DA). |DA| is the absolute value of discretionary accruals. DA is discretionary accruals. The number of observations is 349.

Quarter t)4

Accrual jTAt 4 j jDAt 4 j DAt)4 jTAt 3 j jDAt 3 j DAt)3 jTAt 2 j jDAt 2 j DAt)2 jTAt 1 j jDAt 1 j DAt)1 jTAt j jDAt j DAt jTAt 1 j jDAt 1 j DAt+1

Minimum 0.0007 0.0006 )0.2463 0.0004 0.0002 )0.3188 0.0009 0.0007 )4.7769 0.0001 0.0002 )13.856 0.0002 0.0002 )1.227 0.0019 0.0003 )2.939

Maximum 0.4201 0.4204 0.4204 0.6431 0.6401 0.6401 0.3717 4.7769 4.2867 0.3881 13.8561 2.4991 0.6431 6.7383 6.7383 0.6400 6.3920 6.3920

Mean 0.0555 0.0554 0.0062 0.0587 0.0574 0.0102 0.0543 0.1149 0.0055 0.0550 0.1473 )0.0146 0.0575 0.1371 0.0633 0.0508 0.1143 0.0045

SD 0.0581 0.0584 0.0803 0.0663 0.0671 0.0877 0.0604 0.4317 0.4474 0.0578 0.8018 0.8151 0.0657 0.5881 0.6006 0.0565 0.4734 0.4871

t)3

t)2

t)1

t+1

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Figure 1 The mean values of the accrual that before and after the executive stock options grant date
0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 0.02 0.04

Ratio

The absolute value of total accruals The absolute value of discretionary accruals Discretionary accruals 4Q 3Q 2Q 1Q Quarter Q 2Q

low when executives being awarded equity-based compensation are highly incentivized. Moreover, paying attention to the trend of the absolute value of DA, we inspect the absolute value of DA has increased since the previous three quarters before the ESO grant date. The absolute value of DA reaches a peak on the previous quarter of ESO grant date, which suggests that managers seem to engage in earnings manipulation. Table 3 provides the variables descriptive statistics. The mean value of DA is )0.0353. The mean value of absolute value of DA is 0.1730. As for the control variables, the mean value of market to book ratio is 1.7837. The mean value of debt ratio is 41.8840. 4.2. The Phenomenon of Earnings Management in ESO Grant Date We use the modied Jones model developed by Dechow and Sloan (1995) and add the control variable ROA which is proposed by Kothari et al. (2005) to calculate the DA. Table 4 shows the Dunnetts C test for ANOVA post hoc comparisons. The DA on the concurrent quarter of ESO grant dates are higher than the previous fourth quarter and previous third quarter. This implies that earnings management is more signicant when the ESO grant date is closer. 4.3. The Relationship between CEO Compensation Incentives and Earnings Management Table 5 shows the tests of multicollinearity among variables via the variance ination factor (VIF). All of these variables VIF are less than 10. These results reveal no signicant effect of multicollinearity. Table 6 presents the results on the relation between CEO incentive and earnings management. The dependent variable is the absolute value of DA, which are estimated by using equation (10). Model 1, 2, and 3, the three independent variables, INCEN_O, INCEN_S, and Log_O, are used respectively. In model 4, the abovemen 2012 Korean Securities Association

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Table 3 Descriptive statistics of variables

DA is the discretionary accruals of the concurrent quarter of ESO grant dates. |DA| is the absolute value of discretionary accruals of the previous quarter of ESO grant dates. INCEN_O is the dollar change in the value of manager ESO holdings coming from a 1% increase in the rms stock price. INCEN_S is the dollar change in the value of manager stock holdings coming from a 1% increase in the rms stock price. Log_O is the log of total volume of grant. MTB is the market to book ratio. LEV is the debt ratio. VOEG is the change in net income. Number of observations is 223.

Variable DA jDAj INCEN_O INCEN_S Log\O MTB LEV VOEG

Mean )0.0353 0.1730 0.0952 0.1225 6.9337 1.7837 41.8840 31.3661

SD 0.9997 0.9851 0.1422 0.1739 0.6369 2.5492 14.8464 472.4707

Minimum )1.2270 0.0002 0.0000 0.0000 6.0000 0.0101 5.4300 )2208.6800

Maximum 6.7383 6.7383 0.8725 0.8792 8.6021 36.7978 77.4800 3494.6800

Table 4 Dunnetts C post hoc test

t denotes the current quarter at executive stock option (ESO) grant date; t ) 1, t ) 2, t ) 3, t ) 4 denote previous quarters at ESO grant dates. p-value is reported in parentheses. Number of observations is 223.

|DA| t)4 t)3 t)2 t)1 t F-test

Mean 0.0554 0.0574 0.1149 0.1473 0.1371 2.8053** (0.025)

SE 0.0584 0.0671 0.4317 0.8018 0.5881

Dunnetts C: signicant terms by post hoc test (t ) 2) > (t ) 4) (t) > (t ) 4) (t) > (t ) 3)

tioned three independent variables are simultaneously used. Furthermore, in model 5 followed by model 4, the MTB, LEV, and VOEG are added as control variables. Finally, in model 6 followed by model 5, the quarter is used as a dummy variable to uncover whether earnings management is under the inuence of different quarters or not. In model 1, we only add the incentives of CEO option-based compensation (INCEN_O). The coefcient on the INCEN_O is positive (approximately 2.139) and signicant at the 1% level; this implies a one-standard-deviation increase in CEO option-based compensation (INCEN_O) increases the absolute value of DA by approximately 0.1422 2.139 = 0.304, or 30.4%. In models 2 and 3, we changed the independent variable to the incentive of CEO stock-based compensation
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Table 5 Test of multicollinearity of variables

VIF denotes the variance ination factor. INCEN_O is the dollar change in the value of manager ESO holdings coming from a 1% increase in the rms stock price. INCEN_S is the dollar change in the value of manager stock holdings coming from a 1% increase in the rms stock price. Log_O is the log of total volume of grant. MTB is the market to book ratio. LEV is the debt ratio. VOEG is the change in net income. Q2 is a dummy variable that equals 1 for the second quarter, and 0 otherwise. Q3 is a dummy variable that equals 1 for the third quarter, and 0 otherwise. Q4 is a dummy variable that equals 1 for the fourth quarter, and 0 otherwise.

Variable INCEN_O INCEN_S Log_O MTB LEV VOEG Q2 Q3 Q4 DurbinWatson test

VIF 2.1343 1.8161 3.3120 1.2699 1.0495 1.0536 1.6595 1.8588 1.9192 1.7989

(INCEN_S) and log of total volume of grants (Log_O); however, these variables are insignicant. Additionally, in model 4, we add the incentives of CEO option-based compensation (INCEN_O), the incentive of CEO stock-based compensation (INCEN_S), and log of total volume of grants (Log\O) as independent variables. The coefcients on CEO option-based compensation (INCEN_O) and log of total volume of grants (Log_O) are positive and signicant. A one-standard-deviation increase in total volume of grant (Log_O) increases the absolute value of DA by approximately0.6369 0.086 = 0.055, or 5.5%, which is consistent with our hypothesis that when the rm grants large ESOs to executives DA are actively used. In model 5, we add the MTB, LEV, and VOEG as control variables. In model 6, we add the quarters as dummy variable. In model 6, the coefcient on CEO option-based compensation (INCEN_O) is positive and signicant. A one-standard-deviation increase in this variable leads to an increase in absolute value of DA of 29.62%; option-based compensation has an enormous impact on earnings management. This result is consistent with Bergstresser and Philippon (2006) and Cornett et al. (2008). The coefcient on the CEO stock-based compensation (INCEN_S) is negative and insignicant. This implies CEO stock compensation incentives do not trigger executives to manipulate earnings. The coefcient on the log of total volume of grants Log_O is positive and signicant and indicates that a one-standard-deviation increase in log of total volume of grants increases the absolute value of DA by 5.2%. The result supports our
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Table 6 The relation between CEO incentives and earnings management:

The dependent variable is the absolute value of discretionary accruals. INCEN_O is the dollar change in the value of manager ESO holdings coming from a 1% increase in the rms stock price. INCEN_S is the dollar change in the value of manager stock holdings coming from a 1% increase in the rms stock price. Log_O is the log of total volume of grant. MTB is the market to book ratio. LEV is the debt ratio. VOEG is the change in net income. Q2 is a dummy variable that equals 1 for the second quarter, and 0 otherwise. Q3 is a dummy variable that equals 1 for the third quarter, and 0 otherwise. Q4 is a dummy variable that equals 1 for the fourth quarter, and 0 otherwise. Number of observations is 223. p-values are in parentheses. ***, **, and * denote statistical signicance at 1, 5, and 10% level, respectively.

Variable 0.211*** (0.010) )0.306 (0.422) 0.061 (0.168) 0.686***(0.009) 0.195** (0.042) 2.218*** (0.001) )0.256 (0.479) 0.086** (0.043)

Model 1

Model 2

Model 3

Model 4

Model 5 0.204** (0.047) 2.222*** (0.001) )0.087 (0.386) 0.087** (0.043) 0.016 (0.538) )0.001 (0.828) 0.001 (0.693)

Model 6

Intercept INCEN_O INCEN_S Log_O MTB LEV VOEG Q2 Q3 Q4 Adj. R2 p-value 0.003 0.422 0.004 0.168 0.101 0.001

)0.265*** (0.006) 2.139*** (0.001)

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0.091 0.001

0.091 0.001

0.867** (0.039) 2.083*** (0.001) )0.288 (0.451) 0.081* (0.058) 0.0216 (0.405) )0.001 (0.838) 0.001 (0.422) 0.068 (0.734) 0.469** (0.015) 0.050 (0.781) 0.115 0.001

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Table 7 The relation between CEO incentives and direction of earnings management

The dependent variable is discretionary accruals. INCEN_O is the dollar change in the value of manager ESO holdings coming from a 1% increase in the rms stock price. INCEN_S is the dollar change in the value of manager stock holdings coming from a 1% increase in the rms stock price. Log_O is the log of total volume of grant. MTB is the market to book ratio. LEV is the debt ratio. VOEG is the change in net income. Q2 is a dummy variable that equals 1 for the second quarter, and 0 otherwise. Q3 is a dummy variable that equals 1 for the third quarter, and 0 otherwise. Q4 is a dummy variable that equals 1 for the fourth quarter, and 0 otherwise. Number of observations is 223. p-values are in parentheses. ***, **, and * denote statistical signicance at 1, 5, and 10% level, respectively.

Variable )0.252*** (0.004) 0.182 (0.638) 0.010 (0.823) )0.238*** (0.007) )0.209** (0.017) )2.432*** (0.001) 0.091 (0.804) 0.036 (0.406)

Model 1

Model 2

Model 3

Model 4

Model 5 )0.175** (0.021) )2.439*** (0.001) 0.179 (0.645) 0.037 (0.395) )0.020 (0.454) 0.002 (0.694) 0.001 (0.904)

Model 6

Intercept INCEN_O INCEN_S Log_O MTB LEV VOEG Q2 Q3 Q4 Adj. R2 p-value 0.001 0.638 0.001 0.823 0.107 0.001

0.193** (0.012) )2.398*** (0.001)

Earnings Manipulation on ESO Grants

0.112 0.001

0.098 0.001

)0.153** (0.038) )2.435*** (0.001) 0.185 (0.638) 0.036 (0.412) )0.021 (0.441) 0.002 (0.683) 0.001 (0.862) )0.098 (0.634) )0.100 (0.613) )0.050 (0.786) 0.087 0.001

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hypothesis that enormous grants of ESOs may lead to earnings manipulation. The other control variables have a weaker impact on the absolute value of DA. Table 7 illustrates the relation between CEO incentives and the direction of earnings management. The dependent variable is DA that are estimated by using equation (10). We use the absolute value for DA to capture the direction of earnings management. In model 6, the coefcient on CEO option-based compensation (INCEN_O) is negative and signicant. A one-standard-deviation increase in this variable leads to a reduction in the DA of 34.63%. The negative relation between incentives of CEO option-based compensation and DA is substantiated, which implies CEO optionbased compensation triggers executive downward manipulated earnings. 5. Conclusions Executive stock options are equity-based rather than earnings-based compensation; but the earnings report has a tremendous impact on the value of ESOs. As far as executives are concerned, the more ESOs they hold, the more incentives they have for manipulation. Therefore, this study, focusing on rms in the IT industry in Taiwan that have granted ESOs, attempts to launch a probe into the level of accruals use on the current quarter and the previous ones. We are interested in examining the misfeasance of managers self-interested behavior caused by increasingly interfering in earnings management near the grant date. In advance of the grant date, earnings management is manipulated downward in order to drive down the exercise price and enhance the ESOs value. The results suggest that the more ESOs are awarded to executives, the higher the level of DA. Executives seem to manipulate the reported earnings downwards, as a poor nancial report before grant day may negatively affect the stock price, simultaneously promoting the value of ESOs by cutting their exercise price, which could lead to enhanced value of ESOs. This paper empirically provides evidence that, self-interested executives manipulate earnings for inuencing stock option exercise price; this behavior deviates from the investor s right and violates the purpose of taking the ESOs as one of CEO compensation mechanisms. Therefore, the relation between CEO compensation and earnings management should be taken into consideration, when regulators and board of directors develop the constitution of ESOs. Optimal compensation scheme had better prevent executives from obtaining individuals gains due to unreal reports; otherwise, it may detract from rms value instead of reinforcing their performance. References
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Earnings Manipulation on ESO Grants

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