Executive compensation, earnings management and shareholder litigation

Original Research

Abstract

This paper examines the effects of executive compensation and potential for earnings management on the incidence of shareholder class action lawsuits and their outcomes. Although damage measurement factors, managerial option intensity, and earnings management all significantly affect the probability of lawsuits, they differ in their influence on the likelihood of positive settlement and on settlement amount: Damage factors do not affect the likelihood of settlement versus dismissal. High option intensity raises the probability of positive settlement, but does not affect its amount. High earnings management, on the other hand, does not affect the likelihood of settlement, but does increase settlement amount. These findings suggest that factors typically used to explain shareholder lawsuits should be interpreted with care.

Keywords

Compensation Stock options Fraud Shareholder lawsuits 

JEL Classification

J33 K22 M41 

Notes

Acknowledgments

We appreciate the helpful comments of an anonymous referee, Fabrizio Ferri, Robert Mathieu, and session participants at Eastern Finance Association and Midwest Finance Association conferences. Yan Wendy Wu gratefully acknowledges the financial support of Laurier Center for Economic Research and Policy Analysis and a grant partly funded by WLU Operating funds, and partly by the SSHRC General Research Grant awarded to WLU. All errors are our responsibility.

References

  1. Alexander JC (1991) “Do the Merits Matter?” A study of settlement in securities class actions. Stanf Law Rev 43:497–598CrossRefGoogle Scholar
  2. Baber W, Janakiraman S, Kang S (1996) Investment opportunities and the structure of executive compensation. J Account Econ 21:297–318CrossRefGoogle Scholar
  3. Bauman MP, Shaw KW (2006) Stock option compensation and the likelihood of meeting analysts’ quarterly earnings targets. Rev Quant Financ Account 26:301–319CrossRefGoogle Scholar
  4. Beck JD, Bhagat S (1997) Shareholder litigation: share price movements, news releases, and settlement amounts. Manag Decis Econ 18:563–586CrossRefGoogle Scholar
  5. Beneish MD (1997) Detecting GAAP violation: implications for assessing earnings management among firms with extreme financial performance. J Account Public Policy 16:235–250CrossRefGoogle Scholar
  6. Benmelech E, Kandel E, Veronesi P (2008) Stock-based compensation and CEO (Dis)incentives. NBER Working Paper Series, Working Paper 13732, http://www.nber.org/papers/w13732
  7. Bergstresser D, Philippon T (2006) CEO incentives and earnings management. J Financ Econ 80:511–529CrossRefGoogle Scholar
  8. Black F, Scholes M (1973) The pricing of options and corporate liabilities. J Political Econ 81:637–654CrossRefGoogle Scholar
  9. Burns N, Kedia S (2006) The impact of performance-based compensation on misreporting. J Financ Econ 79:35–67CrossRefGoogle Scholar
  10. Cheng Q, Warfield T (2005) Equity incentives and earnings management. Account Rev 80:441–476CrossRefGoogle Scholar
  11. Choi SJ (2007) Do the merits matter less after the private securities litigation reform act? J Law Econ Org 23(3):598–626CrossRefGoogle Scholar
  12. Core J, Guay W (2002) Estimating the value of employee stock option portfolios and their sensitivieies to price and volatility. J Account Res 40:613–630CrossRefGoogle Scholar
  13. Crocker KJ, Slemrod J (2007) The economics of earnings manipulation and managerial compensation. Rand J Econ 38(No.3):698–713Google Scholar
  14. Dechow P, Sloan R, Sweeney A (1995) Detecting earnings management. Account Rev 70:193–226Google Scholar
  15. Dechow P, Sloan R, Sweeney A (1996) Causes and consequences of earnings manipulation: an analysis of firms subject to enforcement actions by SEC. Contemp Account Res 13:1–36CrossRefGoogle Scholar
  16. Denis DJ, Hauouna P, Sarin A (2006) Is there a dark side to incentive compensation? J Corp Financ 12:467–488CrossRefGoogle Scholar
  17. DuCharme L, Malatesta P, Sefcik S (2004) Earnings management, stock issues, and shareholder lawsuits. J Financ Econ 71:27–49CrossRefGoogle Scholar
  18. Efendi J, Srivastava A, Swanson E (2007) Why do corporate managers misstate financial statements? The role of option compensation and other factors. J Financ Econ 85:667–708CrossRefGoogle Scholar
  19. Erickson M, Hanlon M, Maydew E (2006) Is there a link between executive equity incentives and accounting fraud? J Account Res 44:113–143CrossRefGoogle Scholar
  20. Gaver J, Gaver K (1993) Additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies. J Account Econ 16:125–160CrossRefGoogle Scholar
  21. Goldman E, Slezak SL (2006) An equilibrium model of incentive contracts in the presence of information manipulation. J Financ Econ 80:603–626CrossRefGoogle Scholar
  22. Grundfest JA (1995) Why disimply? Harvard Law Rev 108:740–741CrossRefGoogle Scholar
  23. Haugen R, Senbet L (1981) Resolving the agency problems of external capital through options. J Financ 36:629–648CrossRefGoogle Scholar
  24. Hribar P, Collins D (2002) Errors in estimating accruals: implications for empirical research. J Account Res 40(No. 1):105–134CrossRefGoogle Scholar
  25. Jensen MC (1986) Agency costs of free cash flow, corporate finance, and takeovers. Am Econ Rev 76:323–329Google Scholar
  26. Jensen MC, Meckling W (1976) Theory of the firm: managerial behavior, agency costs and ownership structure. J Financ Econ 3:305–360CrossRefGoogle Scholar
  27. Jensen MC, Murphy KJ (1990) Performance pay and top-management incentives. J Political Econ 98:225–264CrossRefGoogle Scholar
  28. Johnson M, Nelson K, Pritchard A (2007) Do the merits matter more? The impact of the private securities litigation reform act. J Law Econ Organ 23(3):627–652CrossRefGoogle Scholar
  29. Jones J (1991) Earnings management during import relief investigations. J Account Res 29:193–228CrossRefGoogle Scholar
  30. Kothari S, Leone A, Wasley C (2005) Performance matched discretionary accrual measures. J Account Econ 39:163–197CrossRefGoogle Scholar
  31. LeClere M (1992) The interpretation of coefficients in models with qualitative dependent variables. Decis Sci 23:770–776CrossRefGoogle Scholar
  32. Niehaus G, Roth G (1999) Insider trading, equity issues, and CEO turnover in firms subject to securities class action. Financ Manag 28 4:52–72CrossRefGoogle Scholar
  33. Peng L, R¨oell A (2008) Executive pay and shareholder litigation. Rev Financ 12:141–184CrossRefGoogle Scholar
  34. Smith C, Watts W (1992) The investment opportunity set and corporate financing, dividend and compensation policies. J Financ Econ 32:263–292CrossRefGoogle Scholar
  35. Vafeas N (1999) Board meeting frequency and firm performance. J Financ Econ 52:113–142CrossRefGoogle Scholar
  36. Vafeas N, Waegelein JF (2007) The association between audit committees, compensation incentives, and corporate audit fees. Rev Quant Financ Acc 28:241–255CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC 2009

Authors and Affiliations

  1. 1.Department of EconomicsSimon Fraser UniversityBurnabyCanada
  2. 2.School of Business & EconomicsWilfrid Laurier UniversityWaterlooCanada

Personalised recommendations