Should the Outsiders Be Left Out? Director Stock Options, Expectations and Earnings Management

57 Pages Posted: 17 Sep 2011 Last revised: 30 Jun 2012

See all articles by Anwar S. Boumosleh

Anwar S. Boumosleh

Lebanese American University

Brandon N. Cline

Mississippi State University

Adam S. Yore

University of Missouri at Columbia - Department of Finance

Date Written: June 30, 2012

Abstract

We examine the potential confounding effects that awarding outside directors stock options may have on the quality of financial disclosure. By aligning their interests with those of shareholders, directors should be more inclined to monitor and disclose relevant information to investors. Alternatively, stock options increase directors’ compensation sensitivity to firm performance and thus may motivate collusion with management to misreport for short-term financial gain. Our results support the argument that awarding outside directors with options promotes the dissemination of better information to the analyst community. This is reflected in initial forecast errors that are smaller, contain less variance, and have a greater probability of being accurately revised to meet actual earnings in a timely manner, regardless of whether the initial forecasts are positively or negatively biased. A comparison of director and CEO stock options reveals that CEO options only increase the likelihood of lowering overly optimistic expectations; we find no evidence consistent with CEO options increasing the likelihood of walking up pessimistic expectations. Thus, while performance pay to CEOs promotes the practice of maintaining and meeting low expectations, options to outsiders promotes disclosure regardless of the direction of the bias. We find no evidence to suggest director options increase the likelihood of earnings management. Overall, our results indicate that director stock options indeed provide directors with an incentive to promote shareholder interests, but unlike CEO stock options, do not add significant disclosure related agency costs.

Keywords: Director Compensation, Stock Options, Analyst Expectations, Earnings Management

JEL Classification: G3, J33, M4

Suggested Citation

Boumosleh, Anwar S. and Cline, Brandon N. and Yore, Adam S., Should the Outsiders Be Left Out? Director Stock Options, Expectations and Earnings Management (June 30, 2012). Available at SSRN: https://ssrn.com/abstract=1928166 or http://dx.doi.org/10.2139/ssrn.1928166

Anwar S. Boumosleh

Lebanese American University ( email )

P.O. Box 13-5053
Beirut
Lebanon
+961-1-786456 (Phone)

Brandon N. Cline

Mississippi State University ( email )

Mississippi State, MS 39762
United States
662.325.7477 (Phone)
662.325.1977 (Fax)

Adam S. Yore (Contact Author)

University of Missouri at Columbia - Department of Finance ( email )

403 Cornell Hall
Columbia, MO 65211
United States
573-884-1446 (Phone)

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