The Relationship between Executive Pay and Alternative Earnings Measure

INTRODUCTION The objective of this study is to examine the findings of Hanlon et al (2003) and Akindayomi and Warsame (2012) within the context of alternative earnings measure--premanaged earnings1 (1). The findings from these studies show that granting stock options to top executives increase future reported earnings (Hanlon et al) and non-discretionary earnings (Akindayomi and Warsame). The fact that executive pay has come under increased scrutiny in the recent past cannot be ignored. Unquestionably, this scrutiny substantially focuses on top (mostly the top 5) executives in corporate America. While some argue that top executives are over-remunerated, others contend that executive pay tied to performance is appropriate as these executives are motivated to improve corporate performance and thus increase shareholders' wealth. These contradicting positions have extensively attracted the interests of academics/scholars in accounting, economics and finance. However, scholarly research output in this area remains at best contradictory. The genuine challenge posed by the separation of ownership and control is visibly highlighted in the agency research work of Jensen & Meckling (1976). The real agency cost associated with the agency problem in shareholder (principal)/manager (agent) relationship is magnified due to varying interests and the opposing incentive structures of the shareholder and the manager. This creates an incentive alignment gap that must be bridged for the manager to maximize the shareholder's wealth. Executive stock option is one of the widely employed bridging tools in this context. However, the extent to which this compensation tool achieves its anticipated objective remains a practical and an empirical question in compensation research domain. In sum, research findings in this area have been at best inconclusive and controversial. In practice, using executive stock options to remunerate executives continues to increase exponentially in the corporate world. The relative popularity of the choice of stock options among corporations is attested to in the literature. For example, Moran (2002) documents that the use of stock options grew among employee-recipients by about 900% between the late 1990's and the year 2002. In about the same time frame, Bear Stearns & Co reports (see Amromin and Liang, 2003) that stock option grants jumped by 200% relative to corporate operating earnings. Given the preponderance of earnings management evidence in the literature, it is interesting that scholars findings are inconclusive especially (among others) on the relationship between executive compensation (stock options) and managers financial reporting strategies. Even though the literature in these areas has long history, it is still very active. Hence, the motivation for this study. Among others, my study contributes to the literature in the following ways. On one hand, it extends our understanding of the effect of compensation choice on future firm performance especially when one controls for financial misreporting (i.e. earnings management) by managers. On the other hand, it reinforces the incentive alignment findings in Hanlon et al. This is important in that the findings of the current study provides a conclusive evidence that irrespective of the earning measures, remunerating corporate executive with stock options improves future corporate performance and thus align shareholders/managers interests thus minimizing the agency costs. The remainder of the paper continues as follows. Section 2 examines relevant literature and the stated hypothesis. In section 3, I provide the research methodology and design. The empirical results/findings are presented in section 4 while final section is on the summary and the potential limitations of this study. REVIEW ON EXECUTIVE PAY AND EARNINGS MANAGEMENT MEASURES The connection between executive compensation and stock options continues to grow in recent corporate history (see Gritsch & Snyder, 2005). …