Managerial Ownership and Earnings Management: Evidence from Stock Ownership Plans by SSRN
University of Washington – Foster School of Business
May 18, 2015
Stock ownership plans initiate stock ownership requirements for executives. I exploit the initiation of ownership requirements to examine the relation between managerial ownership and earnings management. I document a reduction in earnings management for adoption firms relative to a propensity-matched control sample. Splitting adopters into firms with plans that required increases in ownership and firms with plans that did not, I find the reductions in earnings management are concentrated in firms that required increases in managerial ownership. Additional analysis suggests firms enjoy a reduction in bid-ask spreads following plan adoptions.
Managerial Ownership And Earnings Management: Evidence From Stock Ownership Plans – Introduction
Prior work provides mixed evidence on the relation between managerial ownership and earnings management. Many studies provide evidence of a positive relation between managerial ownership and earnings management, which is consistent with an increase in stock price increasing the portfolio value of high-ownership managers more than the value of low-ownership managers (i.e., the “reward effect”) (Cheng and Warfield 2005; Bergstresser and Philippon 2006; Baber et al. 2009; Johnson et al. 2009). Other work notes that earnings management is a risky activity and posits that risk-adverse managers will be less likely to engage in risky activities as their ownership increases. Consistent with the “risk effect” increasing with managerial ownership, several studies find no relation or a negative relation between earnings management and managerial ownership (Erickson et al. 2006; Hribar and Nichols 2007; Armstrong et al. 2010). Armstrong et al. (2013) note that the theoretical reward effect and risk effect are countervailing forces, and the countervailing forces may explain why prior empirical work finds mixed evidence on the relation between ownership and earnings management. By examining stock ownership plans, a governance reform that limits the reward effect and thus makes the risk effect dominant, I seek to inform the discussion on the relation between ownership and earnings management.
Ownership plans, which require executives to own a minimum level of firm stock by a specified date, provide a novel setting to examine the risk effect and the reward effect. Researchers typically examine the association between managerial ownership and earnings management, while including linear controls for other determinants of earnings management. Levels of ownership are determined by managers, however, and changes in ownership may reflect changes in managers’ expectations of future firm performance. Further, managerial ownership and earnings management are jointly determined by managers. In these settings, it is thus unclear which of the countervailing forces will be stronger. Examining ownership plans provides a distinct advantage relative to examining levels of ownership or voluntary changes in ownership. The adoption of ownership plans induces changes in ownership that are unlikely to be confounded by changes in managers’ expectations (Core and Larcker 2002). Unlike in prior studies, in which managers with high ownership have incentives to sell stock after engaging in earnings management (i.e., reward effect), ownership plans constrain executives’ ability to sell stock to benefit from earnings-management-induced overvaluation. Thus, I posit that plan adopters will experience a decrease in earnings management subsequent to plan adoption.
The following example, which comes from my sample, illustrates how stock ownership plans change managers’ incentives, specifically by reducing the reward effect. Mr. Wilson, as well as other senior executives at Hasbro Incorporated, regularly received stock-based compensation throughout the 1990s. Despite regularly receiving stock, Mr. Wilson kept his ownership level in the firm low for many years by selling stock in 1994, 1996, 1997, 1998, and 1999. In 1999, the board of directors adopted a stock ownership plan that required the named executive officers to hold multiples of their salary in the firm, and the plan thus limited Mr. Wilson’s tendency to sell stock as he received it. The plan became effective in 2000, and it gave executives five years to reach their required ownership level. Mr. Wilson continued receiving stock-based compensation, but the amount of stock he sold dropped dramatically. In the three years before the plan went into effect, Mr. Wilson made stock sales on nine different days, and he received $8.5 million from the sales. In the three years after the plan went into effect, Mr. Wilson made no sales. In the three years before the plan adoption, Mr. Wilson would have increased his before-tax proceeds from stock sales by $85 thousand for each one percent that the stock price was inflated. After the plan was adopted, the ownership plan required Mr. Wilson to increase his ownership in the firm, and his incentives to increase the immediate share price decreased.
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