Academic journal article Journal of Multidisciplinary Research

Granting Stock Options as Part of CEO Compensation and the Impact on Earnings Quality

Academic journal article Journal of Multidisciplinary Research

Granting Stock Options as Part of CEO Compensation and the Impact on Earnings Quality

Article excerpt

Introduction

Due to the increased scrutiny on Chief Executive Officer (CEO) compensation and earnings, the stock options of CEOs is coming under additional accounting scrutiny with the Financial Accounting Standards Board (FASB) issuing Statement of Financial Accounting Standards (SFAS) 123 (R). CEOs receive large amounts of compensation in the form of stock options, even if the company is not making earnings targets. Does the granting of CEO stock options affect earnings quality?

Agency theory has been the primary foundation for research in the relationship between firm performance and executive compensation. The compensation committee develops the compensation structure to converge the motivations of the shareholders and their agents avoiding the agency theory conflict of interest (Jensen & Meckling, 1976; Tosi, Werner, Katz, & Gomez-Mejia, 2000).

This study provides further empirical evidence of the association of granting stock options as part of the CEO compensation plan and earning quality. The more precise the earnings quality of the organization, the more indicative of future cash flows of the firm.

Question 1: Is there a positive relationship between granting CEO stock options and earnings quality?

CEO Compensation

Compensation plans are the payments firm owners make to executives who manage the business. CEO's compensation is comprised of salary, bonus, stock options, restricted stock, and other long-term incentives (Cheng & Färber, 2008). CEO salary and bonus represent a major proportion of the total compensation (Benston, 1985; Lambert & Larcker, 1987). The supplementary major components of compensation other than salary and bonus primarily represent compensation related to long-term performance measures or deferred compensation not explicitly linked to firm valuation. Stock options, stock appreciation rights (SARs), performance units and shares, restricted stock, and phantom stock provide for compensation based on a firm's valuation over several years (Kumar, Ghicas, & Pastena, 1993). Hence, a review of the equity compensation of CEOs provides a different variation of a long-term focus.

Agency Theory

Agency theory is the most basic agency structure, composed of two parties: a principal, who is the owner; and an agent (Holmstrom, 1979). The principal (owner) supplies the capital to the firm, while the agent provides the labor, which may involve effort as well as other decisionmaking responsibilities (Lambert, Larcker, & Weigelt, 1993). Agency theory is the study of the inevitable conflicts of interest that occur when individuals engage in cooperative behavior, which fundamentally changed corporate finance and organization theory, but it has yet to substantially affect research on capital-budgeting procedures (Jensen, 1993).

Earnings Quality

Earnings are high quality if earnings are persistent, an attribute based solely on the time series properties of earnings. Some define earnings as high quality if earnings accurately represent the economic implications of underlying transactions and events. Dechow and Dichev (2002) define earnings by relating current accruals to the last-period, current-period, and next-period cash flows from operations.

Capitahmarket based incentives, contracting incentives, and regulating incentives motivate managers to maximize their own interests and use their discretion over earnings opportunistically (Healy & Wahlen, 1999). Comiskey and Mulford (2000) define earnings as high quality if the contemporaneous cash flows are greater (less) than the recognized revenues or gains (expenses or losses), and low quality if the associated cash flows are less than (greater than) the recognized revenues or gains (expenses or losses). In contrast, Dechow and Dichev (2002) define earnings to be of equal quality for firms with high vs. low realizations of the sum of the error terms if the variance of the sum of the errors for the firms is equal. …

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