EARNINGS MANAGEMENT, BOARD INDEPENDENCE, AND CEO STOCK OPTIONS

Abstract

In the late 1990’s and early 2000’s, financial reporting was beset with many scandals resulting from risky and impractical accounting methods used by firms. In response, the Sarbanes-Oxley Act and other regulations were passed to provide more oversight over financial reporting. This study examines earnings management in the time period after the passage of these. Specifically, I test whether the level of CEO vested in-the-money stock options and board independence impact a firm’s likelihood of earnings management. To determine the degree of earnings management I use a novel measure, a firm’s FSD Score, which is a statistical representation of the firm’s probability of engaging in earnings management using the standard distribution of numbers defined under Benford’s Law. The first conjecture tested in this study is whether the CEO incentives for earnings management are a function of their vested in-the-money stock options. The second conjecture tested is whether a CEO who is more powerful by being in both the CEO and Chairman of the Board (CEO Duality), is more likely to commit earnings management. CEO’s that don’t cash in their vested in-the-money stock options are expecting their firm’s stock to rise and have a greater incentive to indulge in earnings management. The CEO duality would give them more power to influence financial reporting and enable earnings management. I find that whereas the level of vested CEO in-the-money stock options does impact the likelihood of earnings management at a firm, CEO duality does not impact the likelihood of earnings management at a firm.