The Numbers Game: How do Managers Compensated with Stock Options meet Analysts' Earnings Forecasts?

Existing research documents that firms employing relatively high levels of stock option-based compensation more frequently report quarterly earnings that meet or exceed analysts' forecasts. This paper examines the roles of income-increasing accounting choices and management guidance to analysts in this “numbers game.” Our analysis is motivated by increased capital market and Securities and Exchange Commission (SEC) scrutiny of the effects of both stock option-based compensation and financial analysts in capital markets. Using a sample of S&P 1500 firms over 1992-2002, we find that firms that compensate top managers more heavily with stock options employ expectations-reducing guidance to financial analysts, not income-increasing abnormal accounting accruals, to enable them to more frequently meet analysts' earnings targets. The results suggest that rule-making and enforcement aimed at curbing managements' guidance to analysts, rather than narrowing accounting flexibility, might be more effective in tempering the “numbers game.”