Question

The prevalence of stock options in executive pay packages:

Multiple Choice

1. eliminates managers’ incentives to engage in short-term earnings management.

2. is frowned upon by the SEC.

3. may actually contribute to, rather than moderate, managers’ short-term focus.

4. has been widely cited as the main cause of the financial system meltdown that occurred in 2008.

Answer 1

1. The short term earnings can be boosted only through tactical changes in accounting policies and standards. Ultimately the effect catches on in latter periods while doing so. Hence, executives need to focus on long term . However, such short term wishful management of earnings does not completely eliminate executive’s greed. Hence, option (1) is incorrect.

2. SEC provides regulations limiting the amount of stock options executives can get. The body like SEC does not provide opinions rather it has provided certain caps to stock options to executives. Hence, SEC cannot frown but rather provide regulations on these. So, option (2) is incorrect.

3. When stock options are being paid to executives, there is reward to perform higher and higher. This provides executives to look for market opportunity to increase the earnings. Executives deal in the ability to work at the ground where the action is. There is direct benefit of stock options. Stock options can provide both long term and short term focus benefits to executives. So, the option (3) is correct.

4. Although executives had stock options in higher packages than now, this compensation formed a negligible portion of larger game of financial crisis. The financial crisis in 2008 was mainly due to deregulation in derivative market where there was no appropriate derivative laws and regulations. Banks kept on selling more derivatives on housing mortgages to support the derivative instrument they had taken and make it profitable. The primary reason was this and not the stock options to executives which although was high but not high enough to be significant. So, option (4) is not correct.

Hence, option (3 ) is correct i.e. may actually contribute to, rather than moderate, managers’ short-term focus.

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