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Performance-vested Stock Options and Earnings Management


  • Yu Flora Kuang

    1. The author is from the Faculty of Economics and Business Administration, Free University Amsterdam. This paper is based on the author's PhD dissertation at Tilburg University. She thanks her dissertation committee chair Laurence van Lent and co-chair Jeroen Suijs for their generous and consistent guidance in completing this paper. She also appreciates the helpful comments from other committee members, Willem Buijink, Jan Bouwens, Tom Groot, Marleen Willekens, and Marc Wouters. Special thanks to Christopher Ittner, David Yermack, Maarten Pronk, Henri Dekker, Eelke Wiersma, Bo Qin, and Zuzana Sasovova for their valuable suggestions. The author is also grateful to Peter Pope (editor) and an anonymous referee. This paper has benefited from the comments of the seminar participants at Tilburg University, Antwerp University, Mannheim University and the 2005 European Accounting Association annual meeting in Goteborg. All errors are the author's own.
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* Address for correspondence: Yu Flora Kuang, De Boelelaan 1105, 1081 HV Amsterdam, The Netherlands. e-mail:


Abstract:  This paper investigates the effects of performance-vested stock options (PVSOs) on the propensity of managers to engage in earnings management. Using observations from the 240 largest non-financial firms in the UK, I show that managers are more likely to engage in earnings management when they hold a larger proportion of their compensation in PVSOs. When categorizing PVSOs on the basis of their distance from the end of performance periods, the results show that managerial incentives to manage earnings mainly stem from PVSOs that are granted in prior years but within a performance evaluation period (i.e., PVSOs before vesting). Moreover, vesting targets influence the relationship between earnings management and PVSO compensation. The findings are consistent with the earnings smoothing hypothesis: confronted with more ambitious vesting targets, managers who are heavily loaded with PVSOs before vesting will report higher performance by generating greater accounting accruals, whereas in years with good performance, these managers will have incentives to reduce current reported performance by managing earnings downward so they can increase earnings as needed in the future.