Corporate income smoothing tied to CEO stocks and options

Companies who engage in income smoothing by reporting fluctuations in revenue and expenses over time in a way that makes the earnings growth look steady across quarters may be reflecting the CEO’s holdings of stocks and stock options, according to a new study.

The study, by Sydney Qing Shu of San Diego State University and Wayne Thomas of the University of Oklahoma, found that stock grants “are intended to align managers’ actions with shareholders’ interests by linking managers’ and shareholders’ wealth. Consistent with high manager-shareholder alignment, we find that the relation between past income-smoothing and investors' ability to predict future earnings increases with stock holdings. This result is consistent with the information role of income-smoothing.”

In contrast, stock option grants, while also a form of equity-based compensation, “offer a convex payoff structure where the value of the option to the manager relates positively to the volatility of the [underlying asset]. Managers therefore benefit proportionately more from engaging in risky actions ... Consistent with managers' attempting to hide their excessive risk-taking activities (i.e., highly volatile performance) … the relation between income-smoothing and future earnings predictability decreases with option holdings.”

Broadway near the New York Stock Exchange
A pedestrian walks up Broadway near the New York Stock Exchange. Photographer: Michael Nagle/Bloomberg

The study appears in the spring issue of the American Accounting Association's Journal of Management Accounting Research. Previous research has provided two competing explanations for corporate income-smoothing. One is that managers use it “to dampen the volatility of underlying performance caused by their own opportunistic risk-taking behavior,” according to the study’s co-authors. A more benign explanation is that managers “desire to help investors better predict future performance by ... reduc[ing] the volatility of reported earnings caused by transitory items.”

The advantages of having a smooth earnings stream cited by executives in previous research include lower costs of equity, a higher credit rating, greater assurance among customers and suppliers about the terms of trade, and anticipation of higher growth prospects among investors.

The new research only adds to doubts that the earlier research has raised about the effect of executive stock options on corporate management. “Our results relating option holdings to opportunistic income-smoothing echo the recent concern that … option-based compensation induces managerial behavior to the detriment of shareholders,” said the co-authors. “The trend in recent years in equity compensation contracts has been away from stock options and toward restricted stock, although option compensation remains a significant component.”

The findings come from an analysis of 17 years’ worth of information involving approximately 1,700 companies, drawn from a large database of corporate finance and another of executive compensation. The researchers found that for the sample as a whole, a pattern of income-smoothing in the five years prior to a given year increases the predictability of earnings in the three years subsequent to that focal year. But, when the analysis takes into account compensation of company CEOs in focal years, stock holdings and option holdings yield opposite results.

“As stock holdings increase, the association between past income smoothing and predictability of future earnings increases,” said the study. “As option holdings increase, the association between past income smoothing and predictability of future earnings decreases.”

Therefore, the stock holdings prompt managers to “use discretionary accruals to dampen the fluctuations in reported earnings caused by transitory items to better reveal to investors the firm’s underlying (expected future) performance.”

In contrast, “as options increase … discretionary accruals are used by managers to mask the volatility of risky … operations.”

The researchers found that tendency only increases when CEOs had the additional authority of serving as board chairmen, or when they were relatively new to the job and under pressure to prove themselves, or when their options are out of the money (that is, would vest for less than the current price of company shares).

Pointing to the growing tendency in recent years for companies to grant restricted stock, which cannot be sold for a certain period of time, the researchers tested the relationship with income-smoothing and found it to be similar to unrestricted common stock.

In terms of what lessons can be learned from the study’s findings, Shu believes it to be potentially helpful to investors who don’t know whether to be impressed by a company’s smoothly rising earnings or be suspicious. “Check the CEO’s relative holdings of options and stock,” she said. “If the options dominate, proceed with caution.”

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