The Role of Incentives and Accounting in the Design of Executive Compensation Packages

Abstract

We examine firms' use of cash, stock options, and restricted stock in executive compensation packages and the role of optimal incentives and financial reporting costs in those choices. Examining ExecuComp firms in 1995-2001, we find that the deviation from optimal equity incentives explains the role of restricted stock in compensation for CEOs and non-CEO executives. Further, the deviation is negatively related to the use of stock options for CEOs. Surprisingly though, in firms where non-CEO executives' equity portfolios are above optimal, the use of stock options is greater. This finding, combined with our finding that financial reporting costs are negatively associated with the use of cash and restricted stock but positively associated with the use of options, suggests that the use of stock options for non-CEO executives is more for compensatory purposes that avoid an expense than for incentive alignment. Studying firms that begin to voluntarily expense options in 2002 and 2003, we find that these firms reduce the use of stock options and increase the use of restricted stock.