Private Information, Earnings Manipulations, and Executive Stock Option Exercises

This paper investigates the decision by top-level executives of more than 1,200public corporations to exercise large stock option awards in the period 1992-2001. Wehypothesize and find that abnormally large option exercises predict stock return futureperformance. We then hypothesize that this predictive ability represents private information about disappointing earnings in the post-exercise period. Consistent with this hypothesis we find that abnormally positive earnings performance in the pre-exercise period turns to disappointingearnings performance in the post-exercise period, and that this pattern comes as a surprise to even sophisticated market participants (financial analysts). We also hypothesize and find that the disappointing earnings in the post-exercise period represent a reversal of inflated earnings in the pre-exercise period. Collectively, these findings suggest that the private information used by top-level executives to time abnormally large exercises follows from earnings management so as to increase the cash payout of exercises