CEO Risk-Related Incentives and Income Smoothing

We investigate whether risk-related incentives of executive stock option (ESO) compensation plans are associated with income smoothing. Given that risk has both potential benefits and costs, including possible losses and/ or large fluctuations that affect reported financial outcomes, flexibilities in financial reporting enable a manager to lower apparent risk while masking the underlying real risk. As such, income smoothing can be a means by which a manager can reduce the unintended consequences of risk taking without reducing its intended consequences. Using a sample of approximately 7,000 firm-years, we find that risk-taking incentives and income smoothing are positively related. Our results are robust to alternative specifications of income smoothing and risk taking, and to various firm-level characteristics, including governance structures and chief executive officer (CEO) share and option holdings. Additionally, we find that our results are especially pronounced in firms whose risk and risk-taking behavior are high.