Executive option exercises and financial misreporting

Several recent papers document that the magnitude of potential gains from stock-based compensation is positively related to the likelihood of misreporting. In a sample of firms that announce restatements of their financial statements from 1997 to 2002, we examine whether managers realize these potential gains occurring from their accounting choices. After controlling for diversification needs and stock price impact, we find no significant evidence of higher option exercises by executives in the misreported years. However, for firms that are more likely to have made deliberate aggressive accounting choices, we find significant evidence of higher option exercises. For these firms, option exercises are higher by 20-60% in comparison to industry and size matched nonrestating firms. Options exercises by executives are also increasing in the magnitude of the restatement as captured by the effect of the restatement on net income. These higher option exercises tend to be more pervasive and are not just confined to the CEO and CFO of the firm. (C) 2007 Elsevier B.V. All rights reserved.