Corporate governance, stock options and earnings management

Firms often compensate executives with stock options when empirical studies find that these contracts lead to severe earnings management problem. In order to understand the use of stock options as a prevailing compensation strategy in practice, we derive the optimal contract between a firm's shareholders and its manager, the latter of whom exerts unobservable effort and is privately informed about economic earnings as well as his own expertise in managing earnings. The optimal contract is characterized analytically in different corporate governance systems. The model indicates that the inactive region below a threshold in the compensation should be more economically significant when the corporate governance is weaker. The model suggests that, while the use of options leads to earnings management incentives, it is an optimal contract in the presence of reporting latitude and uncertainty over an executives' ability to manage earnings. The model result is in accordance with the observed positive association between the level of earnings management and the use of stock options in both time series and cross section. Empirical evidence on the changes in the intensity of option grants in executive compensation in response to corporate governance legislations also lends support to the model.