The Impact of SFAS 123R on Changes in Option-Based Compensation

Abstract

We investigate the determinants and consequences of the changes in option-based compensation for the top five executives around the issuance of SFAS 123R. We find that the reduction in the proportion of total compensation paid in employee stock options (ESOs) increases in (1) the firm's tendency to take advantage of ESO's favorable accounting treatment to report higher earnings in the pre-expensing period (as proxied by debt contracting concerns, pressure to meet or beat earnings benchmarks and corporate governance strength); and (2) the amount of ESO expense to be recognized upon adopting SFAS 123R (as proxied by the values of annual ESO grants and unvested outstanding ESOs pre SFAS 123R). Our findings are consistent with ESOs' favorable accounting treatment prior to SFAS 123R having a significant effect on boards' executive compensation decisions. We show that firms were more likely to replace ESOs with restricted stock but not with other forms of compensation post SFAS 123R. The substitution between restricted stock and ESOs, however, was far less than dollar for dollar, and that ESO cutbacks around the issuance of SFAS 123R resulted in reduced abnormal compensation.