Equity Incentives and Earnings Management: Evidence from the Adoption of an Anti-Hedging Policy

Abstract

Equity incentives can motivate managers to manage earnings, but the ability to hedge equity incentive portfolios through derivatives may alter this behavior. This study examines whether and how earnings management changes after firms adopt policies prohibiting such hedging. We find that anti-hedging policies increase income smoothing and raise the likelihood of meeting or just beating analysts' earnings forecasts, particularly in firms where managers previously engaged in derivative transactions. Consistent with this mechanism, we find a decline in derivative transactions following policy adoption, with the policy's effect on earnings management more pronounced in these firms. We also find that firms with smoother reported earnings following policy adoption experience a decline in investors' perceived risk. In contrast, we observe no significant changes in corporate risk-taking, CEO wealth exposure, or CEO equity sales following policy adoption. Overall, our findings suggest that anti-hedging policies may unintentionally encourage earnings management, thereby partially attenuating their intended effect of better aligning managerial and shareholder interests.