Discussion of Disqualifying Dispositions of Incentive Stock Options: Tax Benefits vs. Financial Reporting Costs

Abstract

Matsunaga, Shevlin, and Shores (hereafter MSS) examine the impact of the Tax Reform Act of 1986 (hereafter TRA 86) on the desirability of incentive stock options (hereafter ISOs). Using an analysis provided by Scholes and Wolfson [1992], they demonstrate that disqualifying an ISO may have (i) desirable cash flow effects for the firm and (ii) an undesirable impact on reported earnings. For a sample of 88 disqualifying firms and 82 nondisqualifying firms, MSS find some evidence that firms with the highest net tax benefit tended to disqualify their exercised ISOs, whereas firms with the highest financial reporting costs tended not to. These results are interpreted as indicating that firms sacrifice cash flows arising from tax savings because of the adverse impact of the disqualification on reported earnings. Subject to a variety of limitations suggested by the conference participants, this is a useful empirical observation that has implications for the prior work on changes in inventory accounting method, current FASB deliberations on accounting for executive stock options, and understanding the role of financial statement effects on managerial decision making.