Grant Date Research Articles

Stock Price Effects and Determinants of Option Backdating Probe Announcements

The pervasiveness of option backdating practices has resulted in broad regulatory scrutiny, formal investigations by federal authorities and internal inquiries by more than 200 implicated companies. Prior studies (Yermack 1997; Aboody and Kasznik 2000; Lie 2005; Heron and Lie 2006) find a pattern of timing of stock option grants to influence stock prices. Option backdating happens when grant dates are managed retroactively to precede a run-up in underlying shares in an attempt to maximize the option value. We investigate capital market reactions to backdating probe announcements for a sample of 180 implicated companies and the link between such reactions and specific firm attributes. We detect, on average, negative abnormal returns for implicated companies. We also find that the market reaction is more negative for companies that have higher stock price volatility, less effective corporate governance resulting in shareholder lawsuits or departure of their executives, and more leverage. These results have implications for public companies, policy makers, regulators, and the investing and academic communities, as more companies are being investigated by federal authorities and their corporate governance, financial reporting and management integrity are being scrutinized.

On the Use (and Abuse) of Stock Option Grants

E xecutive compensation has long been a topic of significant debate. In recent years, the component of executive compensation packages generating the most controversy has been stock options. Companies use stock options to attract and retain executive talent while strengthening the relationship between executive compensation and performance of the company's stock price. In addition to providing incentives for grant recipients to increase shareholder value, stock options have also been used to reduce corporate taxes and to provide employees with compensation that does not require the company to make an immediate cash outflow. Critics of stock options, however, argue that the true expense of option compensation has historically been concealed in financial reports and that the accounting treatment of stock options, coupled with tax advantages for stock options relative to cash-based compensation, has contributed to an excessive use of option-based compensation. The battle that has taken place throughout the past decade over how to account for the use of options for financial reporting purposes has recently been settled; companies are now required under Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123R), to expense stock options granted to employees by using option-pricing methodologies designed to capture the underlying economic, or "fair," value of the option grant.1 A realistic (i.e., nonzero) estimate of the economic cost to the company of stock option grants must now be recorded as an expense in financial statements. Thus, one might expect that the controversy over the use of stock option grants would settle down. Opponents of stock option expensing argue, however, that companies are now more likely to manipulate other inputs that determine the reported value of option grants. In fact, as of 14 November 2006, at least 173 publicly traded companies have been identified as likely to have backdated stock option grants ("Digging Up Dinosaur Bones II" 2006). Backdating, described by some as the broadest corporate scandal in decades and the largest since the implosion of Enron Corporation, is the practice of selecting option grant dates on a retroactive basis to reflect a lower stock price than the stock price on the date the actual granting decision occurred. Because the number of options that may be granted to executives is often limited or fixed, backdating magnifies the financial gain to the grant recipient by lowering the strike price.2 With the benefit of hindsight, one can see that companies that backdate options are effectively granting in-the-money options. Some legal scholars contend that backdating option grants is simply a choice made by the compensation committee to grant in-the-money options. Although granting in-the-money options is not illegal, companies entangled in the scandal were typically not accounting for the backdated option grants as in-the-money options. As a result, compensation expense was underreported and net income was overreported for financial reporting purposes. Moreover, this practice of granting inthe-money options was usually concealed from shareholders. In addition, executive option plans approved by shareholders frequently specify that the exercise price of the options must not be lower than the fair market value of the stock on the date the grant occurred. The U.S. SEC and U.S. Department of Justice have taken the stance that the concealment of this practice from shareholders and the associated misrepresentation of financial statements constitute financial fraud. Ironically, for tax purposes, the improper accounting often results in an increase in corporate tax deductions, at least for nonqualified option grants. For nonqualified options, the spread between the exercise price and the market price of Randall A. Heron is an associate professor offinance and Tod Perry is an assistant professor of finance in the Kelley School of Business at Indiana University, Indianapolis. Erik Lie is an associate professor and Henry B. Tippie Research Fellow in the Henry B. Tippie College of Business at the University of Iowa, Iowa City.

Does Conservative Stock Option Accounting Lead to Aggressive Cash Flow Reporting?

In this paper, we examine whether recognizing higher option-based compensation expense leads to lower quality operating cash flows when options are exercised. FAS 123(R) changes the classification of the tax benefit from employee stock options in the statement of cash flows by splitting it into two parts: one reported in the operating section and the other in the financing section. Moreover, the proportion reported in the operating section increases with the amount of compensation expense previously recognized. We show that the tax benefit differs from other items of operating cash flows because it has no reliable association with future earnings. We also show that the predictive ability of current period earnings components declines when the tax benefit is classified as an operating cash flow. Finally, we find evidence that investors overprice the tax benefit, suggesting investors do not distinguish it from other operating cash flows. Taken together, our results suggest that the revised treatment of the tax benefit under FAS 123(R) gives rise to a curious situation where more conservative reporting at the grant date increases the proportion of future tax benefits that is included in the operating section, thereby lowering the quality of future reported cash flows.

Executive stock options and dynamic risk‐taking incentives

PurposeThe purpose of this study is to present theory and empirical evidence on whether changes in leverage are systematically associated with changes in the CEO's risk incentives over time.Design/methodology/approach – A model is developed to explain the dynamic relationship between leverage and managers’ risk incentives, and empirically tested with data on executive stock option grants. The model relies on the observation that the risk sensitivity of a call option does not monotonically increase or decrease in the value of the underlying stock.Findings – It is found that changes in the CEO's risk incentives are not systematically correlated with changes in the firm's leverage over time.Research limitations/implications – The near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage, and therefore executives’ incentives to take equity risk are not correlated with firm leverage.Practical implications – For reasonable parameter values, this risk incentive‐maximizing stock price lies very close to the option's exercise price. This finding provides evidence that stock options plans granted approximately at‐the‐money encourage maximum risk‐taking by managers in a dynamic setting.Originality/value – This paper develops theory and evidence to explain why executive stock options are usually granted at‐the‐money.

On the Benefits of Backdating

In this paper we examine options backdating from a wider agency perspective. Recognizing that any options grant will always create timing incentives for managers, we show how the more flexible choice of a grant date implied by backdating actually can mitigate such agency problems. In the absence of backdating, managers can always time investments as to maximize the value of their expected future option grants. While there is no particular wealth-transfer implication of backdating as the wealth consequences are known and can be adjusted for at the time of grant, investment delay however comes at a real economic cost to shareholders. Viewed from an economic perspective, thus, backdating if done right is a shareholder value maximizing feature and thus worth preserving. Explicitly incorporating option pricing theory allows us to quantify managers' incentives. The commonly awarded very long maturity options minimize the sensitivity of the option value to the strike price, and thus minimize moral hazard ahead of an option grant. Our modelling leads to sharp testable implications.

Capital Market Reactions to Option Backdating Probes

The pervasiveness of option backdating practices has resulted in broad regulatory scrutiny, formal investigations by federal authorities and internal inquiries by more than 200 implicated companies. Prior studies (Yermack 1997; Aboody and Kasznik 2000; Lie 2005; Heron and Lie 2006) find a pattern of timing of stock option grants to influence stock prices. Option backdating happens when the actual grant dates are days, weeks, or months before or after their stated date. We investigate capital market reactions to backdating probe announcements for a sample of 180 implicated companies. We detect, on average, negative abnormal returns for implicated companies. We also find that the market reaction is more negative for companies that have higher stock price volatility, less effective corporate governance resulting in shareholder lawsuits or departure of their executives, and more leverage. These results have implications for public companies, policy makers, regulators, and the investing and academic communities, as more companies are being investigated by federal authorities and their corporate governance, financial reporting and management integrity are being scrutinized.

Do formal intellectual property rights hinder the free flow of scientific knowledge?: An empirical test of the anti-commons hypothesis

Although many scholars suggest that IPR has a positive effect on cumulative innovation, a growing “anti-commons” perspective highlights the negative role of IPR over scientific knowledge. At its core, this debate is centered on how intellectual property rights over a given piece of knowledge affect the propensity of future researchers to build upon that knowledge in their own scientific research activities. This article frames this issue around the concept of dual knowledge, in which a single discovery may contribute to both scientific research and useful commercial applications, and finds evidence for a modest anti-commons effect. A key implication of dual knowledge is that it may be simultaneously instantiated as a scientific research article and as a patent. Such patent-paper pairs are at the heart of our empirical strategy. We exploit the fact that patents are granted with a substantial lag, often many years after the knowledge is initially disclosed through paper publication. The knowledge associated with a patent-paper pair therefore diffuses within two distinct intellectual property environments, one associated with the pre-grant period and another after formal IP rights are granted. Relative to the expected citation pattern for publications with a given quality level, the anti-commons perspective suggests that the citation rate for a scientific publication should fall after formal IP rights associated with that publication are granted. Employing a differences-in-differences estimator for 169 patent-paper pairs (and including a control group of other publications from the same journal for which no patent is granted), we find evidence for a modest anti-commons effect (the citation rate after the patent grant declines by approximately 10 to 20 percent). This decline becomes more pronounced with the number of years elapsed since the date of the patent grant and is particularly salient for articles authored by researchers with public sector affiliations.

Pola-pola Perilaku Eksekutif Berkaitn dengan Thapan Penawaran Opsi Saham: Uji Komprehensif di Sekitar Tanggal Hibah

This paper investigates the patterns of executive behavior to the each phase offer of stock option. Executives expected stock prices decreases prior to the grant date with a purpose to obtain the lower exercise and stock prices increases after the grant date with a purpose to obtain the larger gains. While, this study also investigats whether management manage factors of timing and option pricing model with identify the difference behavior of every step stock option offering. The amount of observation are 51 observations and the study finds that executives have ability to manage information around option grant date. The effect is stronger when executives release earnings before option grant date for period prior to ESOP. While, for period after ESOP, the effect is stronger with manage fair value factors are stock price volatility, but do not support for the risk-free interest rate and dividend yield. Based on phases of stock option offering, at prior to employee stock option plan, there are differences of influence of offer of the stock option on earnings management behavior at phase 1 and 2. However compared to phase 2, at phase 1 influence is the sharper than phase 2. After ESOP, slope of phase 3 is sharper than slope of phase 1 and 2.

Backdating of CEO Stock Option Grants and Timing of Earnings Disclosures

Extant studies provide two competing explanations for the abnormal stock return patterns around CEO option grants: the backdating of option grants and the timing of news disclosure. We examine the interrelation between backdating, good-timing, and the regulatory effect on such opportunistic behaviors. Using the CEO option grant sample for SP (2) while the Sarbanes-Oxley Act (SOX) curtailed backdating, the good-timing of earnings disclosures as an alternative device has persisted and increased post-SOX; and (3) the reporting lag between the grant date and the SEC filing date is an indicator of good-timing rather than backdating post-SOX. Overall, our evidence suggests that despite the tightened oversight represented by SOX, CEOs continue to manipulate the timing of earnings disclosures to increase the value of their equity compensation. JEL Classification: M41; M52; K22; G38

The Federal Tax Implications of Redating Stock Option Grant Dates and Exercise Dates

Backdating of stock option grants is receiving substantial investigative attention by the Securities and Exchange Commission, the Department of Justice, the Public Company Accounting Oversight Board, and the Internal Revenue Service. The redating of stock options has significant potential economic and legal implications to executives, employees, and shareholders of the granting firms. Accordingly, this topic is of considerable current interest in both the academic and popular press. In this paper, we discuss the tax implications of manipulating stock option grant and exercise dates, review the tax treatment of stock option and stock purchase plans including I.R.C. §162(m) and I.R.C. §409A implications, and present a real world example illustrating the potential economic magnitude of this problem to both the option grantees and the option granting firms.

Does backdating explain the stock price pattern around executive stock option grants?

Extant studies show that stock returns are abnormally negative before executive option grants and abnormally positive afterward. We find that this return pattern is much weaker since August 29, 2002, when the Securities and Exchange Commission requirement that option grants must be reported within two business days took effect. Furthermore, in those cases in which grants are reported within one day of the grant date, the pattern has completely vanished, but it continues to exist for grants reported with longer lags, and its magnitude tends to increase with the reporting delay. We interpret these findings as evidence that most of the abnormal return pattern around option grants is attributable to backdating of option grant dates.

Accounting for Share-Based Payments

On December 16, 2004, the Financial Accounting Standards Board published FASB No. 123 (revised 2004), which significantly changes the accounting for employee stock options. Under the new standard, equity-based compensation results in a cost to the issuing enterprise and should be measured at its fair value on the grant date, based on the estimated number of awards that are expected to vest. I contend that expensing stock or option grants is not responsive to either the needs of a corporation's creditors, or to the needs of equity investors since the cost of the share-based payments is borne only by the pre-existing shareholders; the corporation itself suffers no sacrifice in assets or other resources (unless its own shares are considered an asset, which is not the case under the present Conceptual Framework and GAAP). Hence I suggest the use of three separate statements instead of the single income statement now provided. Specifically, I propose that the first statement - the Corporation - not include share-based payments as an expense. Rather, a Statement of Costs and Benefits to Pre-existing Shareholders would show the dilution cost to the pre-existing shareholders; this dilution cost would be determined as the amounts that, if accrued during each year throughout the vesting period and until exercise, would cumulatively sum to the intrinsic value at exercise (the price of the optioned share minus the exercise price). A combined Statement of Enterprise Income would then show the totals of the amounts reported in the other two statements. The combined statement would reflect the net income from operations with regard to both the corporation and its pre-existing shareholders; that is, it would reflect the cost of manufacturing products or rendering services.This paper also discusses the implications of this proposal for the debate on the distinctions between liabilities and equities and for the treatment of inseparable compound securities such as convertible bonds.

A Matrix-Based Lattice Model to Value Employee Stock Options

New accounting standards require U.S. companies that give out employee stock options (ESOs) to expense them at fair values as of the grant date. But valuing ESOs is a difficult problem, due to a variety of factors including long vesting periods, nontradability, and „suboptimal” exercise by the holders. In this article, Bajaj, et al develop a valuation algorithm based on combining a binomial lattice with a model for early exercise probabilities. The approach is supported by an empirical analysis of historical exercise behavior for two ESO-granting firms. A dataset covering millions of options awarded over more than 15 years is used to calibrate the early exercise probability matrix. This yields some interesting results, both expected (e.g., early exercise increases with option moneyness) and unexpected (e.g., the effect of time to expiration on exercise probability is clearly nonlinear). The analysis shows that the features of ESOs not taken into account when using the Black–Scholes model for valuation can be quite large–more than 50% of the BS value for one of the companies. <b>TOPICS:</b>Options, statistical methods

Effect of Sarbanes-Oxley Act on the Influencing of Executive Compensation

An analysis of over 569,000 option grant filings by insiders after the imposition of the two-day reporting rule by the Sarbanes-Oxley Act (SOX) reveals that post-grant date market-adjusted stock returns are positive but lower in magnitude than pre-SOX figures, suggesting that SOX has curtailed, but not eliminated, managerial influencing of the grant day stock price. The post-grant date market adjusted stock returns are significantly more positive in the sample of late-reported grants, consistent with stock price influencing either through back-dating the grant date or timing the grant date or information flow with the intent to camouflage. The results suggest that strict enforcement of the two-day reporting rule can significantly reduce managers' ability to use these channels of influence.

Point of View: Expensing Employee Stock Options is Improper Accounting

In December 2004, the Financial Accounting Standards Board (FASB) adopted a new standard of accounting for employee stock options (ESOs). This standard, entitled, Statement of Financial Accounting Standards 123R, requires that ESOs be valued at the date of grant and expensed over the vesting period of the options. The signatories to this position paper strongly oppose this revision to GAAP because they believe that the expensing of ESOs is improper accounting that will result in the serious impairment of the financial statements of companies that are users of broad-based option plans. The case against expensing ESOs can be summed up in six simple statements: an ESO is a in which shareholders agree to share their gains (stock appreciation), if any, with employees; a gain-sharing instrument, by its nature, has no accounting cost unless and until there is a gain to be shared; the cost of a gain-sharing instrument must be located on the books of the party that reaps the gain; in the case of an ESO, the gain is reaped by shareholders and not by the enterprise; the cost of the ESO, therefore, is borne by the shareholders; this cost to shareholders (which, not coincidentally, exactly equals the employee's post-tax profit) is already properly accounted for under the treasury stock method of accounting (described in FAS 128, entitled, Earnings per Share) as a transfer of value from shareholders to employee option holders; and neither the grant nor the vesting of an ESO meets the standard accounting definition of an expense. These six statements lead to the conclusion that an ESO, while it may have an economic cost to shareholders, is not an expense of the entity that grants it.

Which approach to accounting for employee stock options best reflects market pricing?

We use a residual income valuation framework to compare equity valuation implications of four approaches to employee stock options (ESOs) accounting: APB 25 “recognize nothing”, SFAS 123 (revised) “recognize ESO expense”, FASB Exposure Draft “recognize and expense ESO asset” and “recognize ESO asset and liability”. Theoretical analysis shows only grant date recognition of an asset and liability, and subsequent marking-to-market of the liability, results in accounting numbers that capture the dilution effects of ESOs on current shareholder value. Out-of-sample equity market value prediction tests and in-sample comparisons of model explanatory power also support the “recognize ESO asset and liability” method.

Managerial Risk-Shifting Incentives of Option-Based Compensation: Firm Risk, Leverage, and Moneyness

This paper studies the relation between option-based compensation grants and managerial risk-taking behavior. We examine risk-shifting in stock and asset risk, where the unobservable asset risk is estimated using the volatility restriction method and Moody's KMV algorithm in a Merton (1974) framework. Our empirical results provide support for the hypothesis that managers increase stock risk by increasing both asset risk and leverage. Furthermore, our unique dataset allows us to investigate whether grant date moneyness affects managers' risk-shifting behavior. Consistent with recent theoretical predictions we find that out-of-the-money option grants cause increased risk-taking, while deep-in-the-money option grants reduce managerial risk-taking.

An Examination of the Accuracy and Usefulness of Management Earnings Guidance Around Stock Option Grants

The exercise price of stock options is typically the closing stock price on the option grant dates, so managers can potentially benefit from low stock prices on those dates. Prior studies find that on average, managers issue more pessimistic guidance before than after grant dates. They interpret this asymmetric pattern as representing managers’ opportunistic behavior. Nevertheless, it is not clear whether this pattern reflects managers’ selective timing of bad news disclosures or a deliberate misrepresentation of underlying firm performance. This paper extends the literature by examining the effects of managerial stock option incentives on the accuracy and the information content of firms’ voluntary earnings guidance. We find that pre-grant guidance significantly improves existing consensus earnings forecasts, and is similar in bias and accuracy to post-grant guidance. Moreover, investors and analysts react similarly to pre-grant vs. post-grant guidance, suggesting that the main consumers of earnings guidance view these two types of guidance to be equally informative. Our results are consistent with the notion that managers may opportunistically select the type or the timing of disclosures, but when they opt to disclose, they do not misrepresent the underlying firm performance. On the contrary, the seemingly opportunistic guidance before option grants improves overall firms’ information environment, because it is at least as truthful and informative as post-grant guidance, and is issued more frequently than by managers who do not have incentives to report bad news before earnings announcements.

The Dating Game: Do Managers Designate Option Grant Dates to Increase their Compensation?

We provide evidence of a dating game that entails picking a grant date ex-post, i.e., after the board's compensation decision is made. We suggest two variants of the dating game. Back-dating (picking a date in the past with a lower stock price compared to board decision date) if the stock price has been rising prior to the board date, and forward-dating (waiting after the board decision date to observe the stock price behavior) if the stock price has been falling prior to the board date. Using a database of 638,757, option grant filings by insiders between August 29, 2002, and December 31, 2004 we find evidence consistent with both types of dating games. Specifically, we find stock price behavior around the grant date to be positively related to reporting lag, consistent with back-dating. In the promptly reported sample, we find stock return behavior around the grant date and the pattern of reporting lags consistent with forward-dating. Our calculations show that managers can obtain economically significant benefits by playing the dating game.

Recent FSPs on grant date and APIC pool

Journal of Corporate Accounting & FinanceVolume 17, Issue 3 p. 93-96 FASB Recent FSPs on grant date and APIC pool Oscar J. Holzmann, Oscar J. Holzmann University of MiamiSearch for more papers by this authorTom Robinson, Tom Robinson University of MiamiSearch for more papers by this author Oscar J. Holzmann, Oscar J. Holzmann University of MiamiSearch for more papers by this authorTom Robinson, Tom Robinson University of MiamiSearch for more papers by this author First published: 13 February 2006 https://doi.org/10.1002/jcaf.20202AboutPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinkedInRedditWechat Volume17, Issue3March/April 2006Pages 93-96 RelatedInformation