CEO Compensation and Management
Earning Forecast Bias: An Empirical
Analysis
Introduction
Dustin Neal Johnson
School of Business
Managerial Accounting
University of North Carolina at Pembroke
Pembroke, NC 28372
(910)-521-6000
Dnj008@bravemail.uncp.edu
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Abstract
This paper will examine the relation between CEO compensation and the management
earning forecast bias by looking to see how proportional CEOs’ total compensation is to the
accuracy and bias of analysts’ forecast earnings. This assessment with target CEOs stock
options. I hypothesize that the accuracy of the forecast will decrease as the stock option pay
proportion increases. Mangers will be forced to undertake riskier projects as stock option
proportions increase. The riskier projects may include managers have to change or reallocate
their resources, which may lead to changing accounting earnings. Of course, this creates a
chance to create voluntary disclosures, making the complexity of forecasting tougher. I will also
look to examine the existing relationship between the stock option pay proportion and forecast
bias. I will determine that the increase in forecast bias is a result of the increase in the proportion
of stock option pay. With the complexity increasing in forecast because of stock option pay. I
discovered that there is a need to have more access to management’s information for analysts so
that a more accurate forecast can be achieved. My evidence indicates that the accuracy of
analysts’ forecast earning decreases when the proportion of CEOs’ compensation increases from
an increase in stock option.
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CEO Compensation and Management Earning Forecast Bias: An Empirical Analysis
Introduction
It’s not uncommon for businesses, firms, or corporations to compensate their CEO with stock
options. Compensating with stock options is one way in creating incentives for top executives or
CEOs to make decisions for the organizations that will benefit the organization’s shareholders.
Using stock options in this manner creates a link between the top executives or CEOs and
shareholders’ wealth. Of course, this isn’t always a bad way to compensate top officials because
it creates a reduction in the organization’s costs by minimizing the separation of ownership and
control stake inside the business, firm, or corporation; however, the promise of compensation
may make the CEOs or management more incline to make riskier investments.
Over the years there has been numerous studies that focused their attention on the
comparison of other equity forms of compensation and compensation of stock options. One way
of comparing other equity forms of compensation and compensation of stock options is by
looking what occurs with the firm performance, investment decisions, and dividend policy when
one form of compensation is used over the other [ CITATION Kan15 \l 1033 ]. The purpose of
this paper is to address the implications of bias management earning forecast caused by the
compensation of CEOs. I argue that the forecast accuracy will decrease when the total
compensation proportion received by the stock options of CEOs increases. When the stock
options become higher in proportion, managers will become more likely to take on riskier
projects, change accounting earnings by reallocating resources, and voluntary disclosures. The
complexity of forecasting becomes more difficult and less accurate because of the increase in the
stock option compensation proportion. Analysts’ are known for their accuracy in their
forecasting. When forecasting becomes less accurate, analysts’ reputation may take a hit. Of
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course, analysts can easily improve their forecasting accuracy. To do this, the analysts must only
obtain private information from the organization’s management. There are several ways an
analyst may obtain the information for an organization. The best way is creating a good, trusting
relationship with the organization. Most organizations will want something in return from the
analyst, such as a forecast bias. Of course, this agreement works in the analyst’s favor because it
allows the analyst to improve on forecasting accuracy. Keep in mind that the bias in analysts’
forecast earnings increases when the forecasting because more difficult in calculating the
proportion of compensation of CEOs coming from stock options.
In this paper, I will present empirical evidence that I have located from firms in the standard
& Poor’s 500 Index, between the years of 1992-2003, to back my claim that the total
compensation proportion of CEOs derived from stock options affects the accuracy of an analyst’s
bias forecasting earnings [ CITATION Kan15 \l 1033 ]. The evidence will support that analysts
forecast earnings predictions are less accurate as a CEO’s compensation proportion stock options
increase. Also, there will be an increase in forecast optimism [ CITATION Kan15 \l 1033 ]. An
organization stock price can increase, or decrease, depending on an analyst forecasting and an
analyst reputation. Implications from CEO’s compensation and management bias forecasting
are far–reaching, even affecting investors.
Hypotheses Development
In this paper, I will argue that when stock option pay increases for CEOs, rather than cash
compensation, it causes the forecasting task to become more complex for several reasons. My
hypotheses are the following:
H (1): The decrease of analyst’s earning forecast accuracy occurs as the proportion of
CEOs stock option pay increase, resulting in a total compensation increase for CEOs.
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H (2): Optimistic earnings forecast bias of analysts will start to increase when the
proportion of CEO stock option compensation pay increases, again leading to the total
compensation of CEOs to increase.
One reason is because of the options that exist in convex payoffs [ CITATION Kan15 \l
1033 ]. These options sometimes can cause managers who don’t risk takers to switch styles and
accept riskier projects. Sometimes big businesses, firms, or corporations may align themselves
with the mangers and shareholders interest because of the stock option compensation. This is
because it is difficult to track what a manger’s decision by investing will be; however, if there is
an interest to the manger, then it’s more likely the manager will side with his or her best interest [
CITATION Che15 \l 1033 ]. Authors Ragopal and Shevlin of Journal of Accounting and
Economics discover evidence which shows a relationship between executive stock options and
the risk exploration when they study the gas and oil industry [CITATION Raj \p 145-171 \l
1033 ]. Their results were similar to others in determining that there is schemes that occurs with
top executives through convexity from equity risk. The evidence they uncovered suggest that
there was a risk taking incensement when there was incentives for investment. In turn, this
caused the task of forecasting to me more complexed.
Stock option incentive programs are sometimes used to encourage managers to increase
their output through higher work efforts. It is believed that the contributions of a manager will
return a higher performance in the current period, and hopefully in the future periods to come.
Offering managers new incentives has the potential to increase managers’ efforts even more
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because it allows them to utilize and reallocate their effort contributions. With stock option
compensation, managers may put more focuses on improving the organizations long and short
term performances.
A third way those managers are affected by stock option compensation is through a delay
earning recognition with the possibility of incentives [ CITATION Kan15 \l 1033 ]. These
practices also have the chance of causing forecasting to become more complex than usual. These
earning strategies used by management may be formed by the compensation contract by being
influenced [ CITATION Sun \l 1033 ]. Again, when a person receives a stock option pay over a
cash compensation, it increases the compensation contract convexity, which leads to an increase
in earnings management incentives. Of course, managers can easily reduce their compensation
when earnings are low, or increase if earnings are high. This type of behavior will most certainly
cause earnings volatility to increase [ CITATION Kan15 \l 1033 ].
There is also evidence that suggests that when businesses, firms, or corporations release
their voluntary disclosures that it’s in relation to the compensation of stock options [ CITATION
Abo \l 1033 ]. According to suggested evidence, CEOs who are granted their stock option
compensation prior to the release of a forecasting are more likely to have a bad news forecasting
than a CEO who receives their stock option compensation after a forecasting [ CITATION Kan15
\l 1033 ]. The reason behind this is believed to be because managers who are issued stock
options compensations re more likely to use “opportunistic disclosure strategies, the complexity
of the forecasting task increases as the stock option pay relative to cash pay increases
[ CITATION Kan15 \l 1033 ].” This is often more visible with CEOs who are given several
stock option compensation in the same fiscal year.
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All of these reasons suggest that if the proportion of total stock compensation pay in CEO
is increased then there will be an increase the complexity of the task of forecasting, making
forecast less accurate [ CITATION Kan15 \l 1033 ].
Total CEO Compensation and Management Earning Forecast Bias
With the use of a model created by Terence Lim for the purpose of a statistically optimal
forecast with a mean squared error, we may be able to positively identify a predictable forecast
bias [CITATION Lim \y \l 1033 ]. In this model, Lim outlines how analysts will swap out
forecast bias for accuracy in forecasting (Lim). For analysts, there are incentives to create a
more accurate forecast because it allows their compensation and market value to
increase[ CITATION Kan15 \l 1033 ]. As mention above having access to management’s private
information makes improving their accuracy in forecasting a lot easier. Sometimes analysts will
