CEOs with skin in the game: How stock options protect long-term research and development from short-term manipulation

It is a well-known reality that top executives sometimes manipulate financial reports to present a stable, artificially smooth picture of company performance to investors. While some of this is done through accounting choices (accruals), a more damaging method is "real earnings management", that includes cutting or delaying vital Research & Development (R&D) projects just to hit short-term earnings targets. This practice sacrifices a company's long-term growth simply to appease the stock market or secure a year-end bonus.

In new research forthcoming in the journal Accounting and Business Research, Li Yao, an associate professor in the Department of Accountancy at the John Molson School of Business, and co-authors investigate how the design of a CEO's compensation package can stop this harmful behaviour.

Key finding

The research reveals that awarding CEOs stock options significantly reduces their temptation to manipulate R&D spending over multiple periods, that is, to smooth earnings through R&D. The underlying intuition is that well-designed stock options increase in value when a company takes on profitable, albeit risky, long-term projects. Because R&D is inherently unpredictable, it naturally creates ups and downs in earnings. Stock options encourage CEOs to embrace this natural volatility and pursue valuable innovation, rather than playing it safe and slashing R&D budgets just to manufacture smooth financial results. In short, when CEOs are financially rewarded for taking calculated risks, their interests are aligned with the long-term success of their companies' innovation pipeline.

Crucial blind spots

The study highlights that stock options are not a universal cure. The risk-reward incentives of stock options break down under severe short-term pressure. Specifically, stock options are less effective in preventing R&D manipulation in the following three scenarios.

Newly appointed CEOs: Leaders who have just taken over often feel intense pressure to prove themselves immediately to the market, leading them to prioritize short-term numbers over long-term incentives.

Inexperienced CEOs: Newer executives who are still building their professional reputations in the labour market are more likely to manipulate earnings to avoid early career missteps.

Companies facing extreme losses: When a company experiences severe financial distress, the CEO's concern for job security appears to outweigh consideration of the potential future payouts of their stock options, resulting in R&D manipulation.

For practitioners and boards of directors, the takeaway is clear

Stock options are an effective tool for encouraging CEOs to protect long-term R&D and avoid artificially smoothing earnings. However, boards cannot rely on compensation structures to function on autopilot. During leadership transitions, or periods of severe financial turbulence, more active board oversight becomes essential, as standard compensation incentives may fail to deter executives from cutting vital R&D investment to pursue short-term financial performance.