Stock option modification under SFAS 123(R)

Abstract

Purpose – The purpose of this paper is to examine the motivations for and variations in terms of stock option modifications under Statement of Financial Accounting Standards (SFAS) 123(R). Stock options are used to motivate and retain employees. Unfortunately, when stock prices decline, existing options lose their incentive value. In response, firms look for ways to re-incentivize their employees. Their choices include issuing additional options and/or modifying existing grants. Design/methodology/approach – We investigate the economic determinants of stock option modification post SFAS 123(R), such as financial reporting cost, shareholder/political cost and employee incentive and retention. Our analysis is based on 67 sample firms that modify their stock option plans from 2005 to 2008 and 67 control firms constructed based on size, industry, year and stock price performance for the prior five years. Findings – The results show that loss firms are more likely to modify their options, which supports the argument that financial reporting costs influence the decision to modify. We find support for the shareholder/political costs hypothesis, as the overhang ratio is positively associated with the decision to modify. However, we find no evidence that modifications substitute for additional option grants. We find that politically sensitive larger firms are more likely to incorporate more shareholder friendly measures such as excluding executives from modification or providing shareholders the opportunity to vote on modification. Originality/value – This is the first paper examining the economic determinants of stock option modification under SFAS 123(R). Our findings provide some insights regarding economic determinants of SFAS 123(R) for accounting policy-makers and investors.