Incentive Compensation and ESO Expensing Under SFAS No. 123 and 123(R)

Abstract

In December 2004, FASB issued a revised SFAS No. 123, Share-Based Payment, and required public companies to expense employee stock options (ESOs). Top executives at major corporations strongly opposed ESO expensing, citing many conceptual and implementation issues. They argue, for example, ESOs are a private arrangement between employees and shareholders and the related expense does not constitute an expense to the firm. They also argue the models that FASB recommends to calculate the fair values of ESOs, such as Black and Scholes and binomial models, are unsuitable for ESOs. This study finds that annual CEO cash compensation is negatively associated with ESO expense in the period 1996-2005, the only period for which ESO expense was publicly available for many firms and also a period in which ESO expense was disclosed but not recognized. If disclosed ESO expense affects CEO compensation, recognized ESO expense is likely to not only do so but do so to a greater extent. Our result therefore provides an alternative explanation for why firms oppose fair value ESO expensing. The result also makes it less likely that managers opposed fair value ESO expensing primarily because of conceptual and measurement issues, notwithstanding their public statements to the contrary.