Managerial Ownership and Earnings Management

In my paper, Managerial Ownership and Earnings Management: Evidence from Stock Ownership Plans, which was recently made publicly available on SSRN, I exploit the initiation of ownership requirements to examine the relation between managerial ownership and earnings management. Prior work provides mixed evidence on the relation between managerial ownership and earnings management. Many studies provide evidence of a positive relation between managerial ownership and earnings management, which is consistent with an increase in stock price increasing the portfolio value of high-ownership managers more than the value of low-ownership managers (i.e., the “reward effect”) (Cheng and Warfield 2005; Bergstresser and Philippon 2006; Baber, Kang, Liang, and Zhu 2009; Johnson, Ryan, and Tian 2009). Other work notes that earnings management is a risky activity and posits that risk-adverse managers will be less likely to engage in risky activities as their ownership increases. Consistent with the “risk effect” increasing with managerial ownership, several studies find no relation or a negative relation between earnings management and managerial ownership (Erickson, Hanlon, and Maydew 2006; Hribar and Nichols 2007; Armstrong, Jagolinzer, and Larcker 2010). Armstrong, Larcker, Ormazabal, and Taylor (2013) note that the theoretical reward effect and risk effect are countervailing forces, and the countervailing forces may explain why prior empirical work finds mixed evidence on the relation between ownership and earnings management. By examining stock ownership plans, a governance reform that limits the reward effect, I seek to inform the discussion on the relation between ownership and earnings management.

Ownership plans, which require executives to own a minimum level of firm stock by a specified date, provide a novel setting to examine the risk effect and the reward effect. Researchers typically examine the association between managerial ownership and earnings management, while including linear controls for other determinants of earnings management. Levels of ownership are determined by managers, however, and changes in ownership may reflect changes in managers’ expectations of future firm performance. Further, managerial ownership and earnings management are jointly determined by managers. In these settings, it is thus unclear which of the countervailing forces will be stronger. Examining ownership plans provides a distinct advantage relative to examining levels of ownership or voluntary changes in ownership. The adoption of ownership plans induces changes in ownership that are unlikely to be confounded by changes in managers’ expectations (Core and Larcker 2002). Unlike in prior studies, in which managers with high ownership have incentives to sell stock after engaging in earnings management (i.e., reward effect), ownership plans constrain executives’ ability to sell stock to benefit from earnings-management-induced overvaluation. Thus, I posit that plan adopters will experience a decrease in earnings management subsequent to plan adoption.

The following example, which comes from my sample, illustrates how stock ownership plans change managers’ incentives, specifically by reducing the reward effect. Mr. Wilson, as well as other senior executives at Hasbro Incorporated, regularly received stock-based compensation throughout the 1990s. Despite regularly receiving stock, Mr. Wilson kept his ownership level in the firm low for many years by selling stock in 1994, 1996, 1997, 1998, and 1999. In 1999, the board of directors adopted a stock ownership plan that required the named executive officers to hold multiples of their salary in the firm, and the plan thus limited Mr. Wilson’s tendency to sell stock as he received it. The plan became effective in 2000, and it gave executives five years to reach their required ownership level. Mr. Wilson continued receiving stock-based compensation, but the amount of stock he sold dropped dramatically. In the three years before the plan went into effect, Mr. Wilson made stock sales on nine different days, and he received $8.5 million from the sales. In the three years after the plan went into effect, Mr. Wilson made no sales. In the three years before the plan adoption, Mr. Wilson would have increased his before-tax proceeds from stock sales by $85 thousand for each one percent that the stock price was inflated. After the plan was adopted, the ownership plan required Mr. Wilson to increase his ownership in the firm, and his incentives to increase the immediate share price decreased.

I use four earnings management measures to examine whether ownership plans are associated with a reduction in earnings management: (1) firms’ propensity to meet or just beat prior-year earnings, (2) abnormal accruals, (3) abnormal discretionary expenditures, and (4) channel stuffing. To estimate the effect of a mandatory increase in ownership on my measures of earnings management, I use propensity-score matching to select control firms. The matching procedure selects firms that exhibit similar characteristics related to the adoption of ownership plans as the adopters, but that did not actually adopt ownership plans. I examine inter-temporal changes in my measures of earnings management for a sample of ownership plan adopters relative to my control firms. Consistent with ownership plans leading to a reduction in earnings management, I document a reduction in the propensity to meet or just beat prior-year earnings and real earnings management through discretionary expenditures for firms that adopted ownership plans relative to a propensity-matched control sample. In my full sample analysis, I find no evidence of a reduction in channel stuffing or earnings management via abnormal accruals after the adoption of an ownership plan.

The variation in the characteristics of ownership plans allows me to further explore the relation between ownership and earnings management. Some firms adopt ownership plans that do not require any executives to increase their ownership level, and other firms adopt plans that require one or more executives to increase their ownership. I exploit this variation and study the effect of adoption on earnings management for both firms that require ownership increases and firms that do not. I create a dataset that contains the ownership requirements and current ownership of all named executive officers at firms that adopted an ownership plan. When examining the subset of adoption firms that require an ownership increase for at least one executive, I find evidence of a reduction in earnings management for all four of my measures. For firms that adopted ownership plans that required no additional ownership for any named executive officer, however, I do not find evidence that ownership plans lead to a reduction in earnings management for any of my four measures. These results suggest that it is the required increase in ownership, rather than simply the adoption of an ownership plan, that leads to a reduction in earnings management. This cross-sectional test mitigates concerns that an unidentified driver, rather than the increase in ownership after plan adoption, which leads to lower earnings management.

The full paper is available for download here.