Financial Reporting Concerns, Framing Effects and Employee Stock Option Grants

Abstract

Managers are concerned about reported earnings (e.g., Graham et al. 2005). The favorable accounting treatment for employee stock options (ESO) available under the pre-expensing regime lead managers to frame ESOs as cheap to grant (e.g., Murphy 2002 2003; Hall and Murphy 2003; Jensen and Murphy 2004). This paper tests two effects of framing in the context of employee stock option grants: the reference-point-dependent preferences and the ratio-difference principle. I analyze stock option grants to CEOs, the other top 4 executives, and non-executive employees in 859 firms from 1996 to 2002. I find that firms grant more stock options when doing so helps them to meet or beat earnings targets, consistent with the notion of reference-point-dependent preferences in prospect theory. Further, I analyze the relationship between the extent of potential expense saving and stock option grants. I find that firms grant more options when granting stock options have a bigger impact on reported earnings, consistent with the ratio-difference principle in mental accounting theory. In sum, results suggest that management decision making of ESO grant is subject to framing effects.