Stock Option Exercise, Earnings Management, and Abnormal Stock Returns

This essay uses a large sample to examine whether stock option plans provide incentives to executives to manage earnings when exercising their options. The evidence presented is consistent with a hypothesis where managers use accruals to shift earnings to increase the stock price prior to and during option exercise periods. However, the results indicate that the magnitude of earnings management related to stock options may be limited. Reported income peaks at the earnings announcement immediately preceding option exercise activity and is followed by both reversals in income and discretionary accruals as well as negative abnormal stock returns during the post-exercise period for up to one year. Current discretionary accruals range from 0.3% to 0.62% of assets, depending upon the accrual model, during the quarterly earnings announcement immediately preceding option exercise activity. Over the two quarters following option exercise, sample firms experience small but statistically significant reversals in discretionary accruals and on average experience negative abnormal returns of approximately -3%. The magnitude of the return reversals is shown to be cross-sectionally positively related to the magnitude of the pre-exercise discretionary accrual proxies, even after adjusting for the Sloan anomaly. I find similar evidence for a sample of firms that experience option expiration but weaker evidence of earnings management for stock sales unrelated to stock option exercise.