Earnings Management for Unloadable Equity Holdings and Earnings Response Coefficient

Abstract

Prior research examines the relation between the amount of annual option exercises and discretionary accruals, which are a conventional tool for earnings management. I differentiate from prior studies by exclusively focusing on the vested portion of equity-based compensationspecifically, exercisable stock options and vested restricted stocks. Bebchuck and Fried (2010) provide multiple anecdotal evidences such that managers holding vested equity compensation are tempted to influence stock prices in various manners because they can immediately unwind the equity incentive portion into cash. Another key difference of this paper form the prior literature is that I apply the concept of earnings response coefficients (ERCs hereafter) to the perverse relation between long-term equity incentive and short-term earnings management. I find that when the ERC is interacted with the equity incentive, I find the size of earnings management (in terms of performance-matched discretionary accruals) becomes significantly larger. I interpret that managers of firms with the higher ERC can enjoy more benefits from creating positive abnormal accruals because share prices respond to the greater extent on the earnings information. Next, the empirical analysis shows that earnings persistence impairs as the size of unloadable equity holdings grows and this negative association prevails particularly when the ERC is higher. The results collectively provide a new insight to the earnings management literature from the perspective of earnings-return sensitivity.