Option Expense Research Articles

Managerial risk-taking incentives and cash holding in U.S. firms: Evidence from FAS 123R

Employing FAS 123R, which mandated option expensing, as a quasi-natural experiment, we investigate the causal effects of CEO risk incentives (vega) on cash policies of U.S. firms. Employing a difference-in-differences framework with propensity-score matching, we find no association between changes in CEO portfolio vega and corporate cash holdings, including the marginal value of cash. Our finding applies to both firms most and least affected by the regulatory change. Thus, our evidence challenges the view that stock options are a first-order determinant of corporate cash policy, implying that any previously documented relation may reflect endogeneity rather than a causal influence.

МЕТОДОЛОГІЯ ОЦІНЮВАННЯ ЕФЕКТИВНОСТІ ПРОЄКТІВ ДЕРЖАВНО-ПРИВАТНОГО ПАРТНЕРСТВА

Анотація. Узагальнено аргументи і контраргументи в межах наукової дискусії з питання визначення основних методологічних засад аналізу ефективності здійснення державно-приватного партнерства. Основною метою проведеного дослідження є виокремлення та аналіз методів оцінювання ефективності державно-приватного партнерства та спричинених ним ефектів. Систематизація літературних джерел і підходів до розв’язання проблеми засвідчила, що існує велика множина методологічних принципів оцінки ефективності державно-приватного партнерства, що розкривають інвестиційний, економічний, фінансовий, соціальний та інші аспекти його реалізації і можуть бути адаптовані та агреговані в загальну методику, що відображатиме оцінювання всіх альтернативних варіантів отримання доходів i витрат. Актуальність розв’язання цієї наукової проблеми полягає в тому, що доцільність реалізації масштабної програми реалізації проєктів державно-приватного партнерства є значною, а єдиного методологічного підходу до оцінювання їхньої ефективності немає, що призводить до появи подвійного рахунку та неврахування важливих ефектів різного виду і масштабності. Дослідження питання визначення методологічних засад оцінювання ефективності проєктів державно-приватного партнерства здійснено в такій логічній послідовності: визначення кількісних та якісних критеріїв оцінювання ефективності реалізації партнерства, виокремлення видів ефектів від цього реалізації із зазначенням основних показників ефективності та привабливості. Методичним інструментарієм проведеного дослідження стали методи порівняння при реалізації наукової дискусіє з питань визначення основних засад реалізації державно-приватного партнерства, наукової абстракції — при визначенні можливих ефектів впливу зростання ефективності реалізації державно-приватного партнерства на національну економіку як на макро-, так і на мікрорівні, моделювання — при формуванні загальних методологічних принципів оцінки партнерства. Об’єктом дослідження обрано проєкти державно-приватного партнерства. Результати проведеного дослідження можуть бути корисними для формування державних програм реалізації державно-приватного партнерства у всіх сферах народного господарства. Ключові слова: проєкти, державно-приватне партнерство, методологія оцінювання, показники ефективності державно-приватного партнерства. JEL Classification М10, М48 Формул: 3; рис.: 0; табл.: 0; бібл.: 18.

Executive compensation and corporate risk-taking: Evidence from private loan contracts

We examine how management stock options affect corporate risk taking. We exploit exogenous variation in stock option grants generated by FAS 123R and use loan spreads to infer risk taking. Using a difference-in-differences approach, we find that the spreads of loans taken by firms that did not expense options before FAS 123R (treated firms) significantly decrease after FAS 123R relative to firms that either did not issue stock options or voluntarily expensed stock options before 123R (control firms). We also find that the effect is stronger for firms with high agency conflicts associated with risk-shifting. Furthermore, loans taken by the treated firms are less likely to contain collateral requirements and are less likely to have covenants restricting capital investment post FAS 123R.

Why Did Politicians Intervene in the Fair Value Debate? The Role of Ideology and Special Interests

Politicians frequently intervene in the regulation of financial accounting. Evidence from the accounting literature shows that regulatory capture by special interests helps explain these interventions. However, many accounting rules have broad economic or social consequences, such as their effects on income distribution or private-sector subsidies. The perception of these consequences varies with a politician’s ideology. Therefore, if accounting rules produce those consequences, ideology plausibly spills over and explains a politician’s stance on the technical accounting issue, beyond special interest pressure. We use two prominent U.S. political debates about fair value accounting and the expensing of employee stock options to disentangle the role of ideology from special interest pressure. In both debates, ideology explains politicians’ involvement at exactly those points when the debate focuses on the economic consequences of accounting regulation (i.e., bank bailouts and top-management compensation). Once the debates focus on more technical issues, connections to special interests remain the most dominant force.

Why Do Politicians Intervene in Accounting Regulation? The Role of Ideology and Special Interests

ABSTRACTPoliticians frequently intervene in the regulation of financial accounting. Evidence from the accounting literature shows that regulatory capture by special interests helps explain these interventions. However, many accounting rules have broad economic or social consequences, such as their effects on income distribution or private sector subsidies. The perception of these consequences varies with a politician's ideology. Therefore, if accounting rules produce those consequences, ideology plausibly spills over and explains a politician's stance on the technical accounting issue, beyond special interest pressure. We use two prominent U.S. political debates about fair value accounting and the expensing of employee stock options to disentangle the role of ideology from special interest pressure. In both debates, ideology explains politicians’ involvement at exactly those points when the debate focuses on the economic consequences of accounting regulation (i.e., bank bailouts and top management compensation). Once the debates focus on more technical issues, connections to special interests remain the dominant force.

Executive Pay and Labor’s Shares: Unions and Corporate Governance from Enron to Dodd-Frank

AbstractThis article is an historical analysis of the U.S. labor movement’s shareholder activism during the 2000s, which was based on their pension-plan assets. During the previous decade, corporate governance had tilted to give shareholders greater voice in corporate decisions. The protagonists were public pension plans such as CalPERS. Come the 2000s, they were replaced by unions and union-influenced pension plans. Their agendas overlapped but union investors were distinctive in their use of shareholder activism to make companies more public-minded, raise labor’s organizing power, and challenge executive power by reliance not only on shareholder activism but also political activities. Labor’s signature issue was executive pay, which was a topic that that shareholder activists during the 1990s had avoided other than to push for stock-based pay. But three waves of corporate scandals during the following decade caused other shareholders to become skeptical of executive pay-setting methods. Union investors zeroed in on expensing and backdating of stock options, and fought for say on pay, the issue where they had the greatest impact. An interaction between private orderings and regulation now developed, whereby shareholder pay reforms found their way into law. With inequality a major social concern, unions repeatedly contrasted lofty executive pay to stagnant wages. Yet little was said about lofty payouts to shareholders, which may have been a more important driver of inequality than executive pay. The article ties corporate governance to larger social and political developments in the U.S., and to the labor movement, embedding corporate governance in historical context.

The effects of SFAS-123R on corporate investment

ABSTRACTThis study examines the effects of mandatory expensing of stock options on corporate investment after the passage of SFAS-123R. First, we find an increase in corporate investment such as R&D investment and capital expenditure in the post-SFAS-123R period. Second, we find that stock-based compensation such as stock option compensation and restricted stock in the post-SFAS-123R period is positively related to investment. Our findings suggest that SFAS-123R discourages the opportunistic use of stock option compensation. The use of option compensation in the post-SFAS-123R era appears to encourage managers to pursue more long-term investment, which suggests that the SFAS-123R has had positive consequences.

Does Option-Based Compensation Affect Payout Policy? Evidence from FAS 123R

Does option-based compensation affect payout policy? To address this question, we examine the adoption of mandatory expensing of stock options. Our identification strategy exploits the fact that the reduction in option-based compensation after the accounting change varies with the firm-specific expected accounting impact. Across a battery of tests, we do not find that (accounting-driven) reductions in option-based pay cause dividends to increase or repurchases to decrease. Our results contrast with the widely held belief that option-based pay has a significant causal influence on payout policy and cast doubts on its role in the shift from dividends to repurchases.

CEO incentive pay around performance declines

PurposeThe authors study stock and option grants around abrupt performance declines for continuing CEOs and find that firms facing abrupt financial declines grant more options than stock, while firms facing operational decline grant more stock than options. Firms making these adjustments just prior to performance declines outperform those that do not for three years following the decline and are less likely to engage in asset restructuring. To establish causality, the authors exploit compensation changes instigated by FAS 123R accounting regulation in 2005 that mandated stock option expensing. The result is robust to numerous tests, including rebalancing of incentives and CEO turnover. The paper aims to discuss these issues.Design/methodology/approachTo establish causality, the authors exploit compensation changes instigated by FAS 123R accounting regulation in 2005 that mandated stock option expensing.FindingsFirms making these adjustments just prior to performance declines outperform those that do not for three years following the decline and are less likely to engage in asset restructuring. The result is robust to numerous tests, including rebalancing of incentives and CEO turnover.Originality/valueSeveral studies examine the relationship between poor performance and compensation of newly appointed CEOs. But firms regularly employ retention or incentive plans when experiencing distress to prevent critical employees from leaving when they are most needed (Goyal and Wang, 2017). Employee turnover results in a loss of continuity coupled with high search and training costs for replacement personnel. Beneish et al. (2017) find that 57 percent of CEOs associated with intentional misreporting retain their jobs, implying the costs of removing CEOs is high, especially if the incumbent CEO has a strong track record relative to industry peers prior to the period before the misreporting begins. The board fires the CEO if future firm value under the CEO is expected to be lower than under the best alternative CEO less adjustment costs (e.g. search costs, severance pay).

The Evolution of Employee Compensation, Dilution, and Payout Policy

Employee compensation may impact payout policy by (i) incentivizing managers with non-dividend-protected options to favor repurchases over dividends and (ii) diluting earnings, which firms can neutralize through share repurchases. Both the dividend-protection and dilution channels imply a positive relation between stock options and repurchases. Yet, recent studies and trends suggest repurchases do not decline when option usage falls around mandatory option expensing, casting doubt upon a causal relation between equity compensation and payout. We examine this relation in light of the shift from options to restricted stock. Our results strongly support a positive relation between compensation and share repurchases via the dilution channel; dividend protection has no first-order effect on payout. Difference-in-differences analyses using a shock to compensation around mandatory option expensing and an instrumental variable approach suggest that the relation between dilution and payout is likely causal. Further, as the dilution channel predicts, equity compensation positively relates to repurchase frequency and timing.

Investing in vertical integration: electricity retail market participation

Electricity industries are frequently characterised by a high degree of vertical integration. We explore the option for a generator to enlarge its participation in the retail market, and show that the firm will choose to delay if market demand is too high or low. In the former case, high wholesale prices may make fixed price retail customers unattractive, while in the latter, too little revenue is earned to justify the option's expense. Increased volatility can, under some circumstances, lower the value of the option, contrary to conventional real options theory. Firms expand their retail positions more aggressively in concentrated markets, vertically integrated markets, and markets where financial hedging is prevalent.

Cash Holding in U.S. Firms: Evidence from FAS 123R

Using exogenous variation in CEO stock option grants generated by FAS 123R which mandated expensing of employee stock options, we investigate the causal effects of CEO risk incentives (vega) on cash policies of U.S. firms. Employing a difference-in-difference framework, in which we identify firms most affected by the regulatory change, we find no evidence that changes in CEO portfolio vega lead to significant changes in corporate cash holdings and the marginal value of cash. Our evidence challenges the view that option-based compensation is a first-order driver of corporate cash policy and instead implies that previously documented associations perhaps reflect endogeneity rather than a causal influence.

Non-dividend protected executive options and dividend policy: Evidence from SFAS 123R

We examine how granting non-dividend protected executive options affects payout policy during the period 2001–2008. Using a difference-in-difference estimation along with the introduction of SFAS 123R, we find that firms with non-optioned executives increase dividends more than firms with optioned executives, post- versus pre-SFAS 123R. Our result questions whether non-dividend protected executive options are an impediment to paying dividends. Our result is robust pre-SFAS 123R dividends, consistent and inconsistent dividend payers and firms dropping options completely post-SFAS 123R, as well as controlling for endogeneity. Our evidence suggests that expensing of options has no effect on dividend policy.

The Effect of Option-Based Compensation on Payout Policy: Evidence from FAS123R

Does option-based compensation have a causal influence on payout policy? To address this question we examine the adoption of mandatory expensing of stock options (via accounting standard FAS123R), a plausible exogenous shock to the use of option-based compensation. As FAS123R applies to all firms, our identification strategy exploits the fact that the reduction in option-based compensation in response to the accounting standard varies with the firm-specific expected accounting impact, as measured by the option expense disclosed in the footnotes prior to FAS123R. Using a difference-in-difference research design we do not find that (accounting-driven) reductions in option-based pay cause dividends to increase, repurchases to decrease or the payout composition to change, except for some increase in dividends among dividend-paying small firms. Our results contrast with the widely held belief that option-based pay has a significant causal influence on payout policy and cast doubts on its role in the shift from dividends to repurchases in recent decades.

Managing Employee Stock Option Expense: A Fair Value Approach

Owing to special characteristics, classic option pricing models are not well suited to the valuation of employee stock options (ESOs). This paper attempts to conduct a more general fair value estimation based on attaching performance targets to option vesting. Considering a setting that includes factors such as options that may be exercised early at employee discretion, employee exit rates and firm default risk, this paper presents a sensitivity analysis and empirical tests of option value. The results highlight the importance of considering the characteristics of ESOs in the design of performance‐vested option plans so as to provide the most attractive incentives for employees.

CEO pay disparity: Efficient contracting or managerial power?

This paper investigates whether CEO pay disparity reflects efficient contracting or managerial power by exploiting a quasi-natural experiment which mandated option expensing, FASB ASC 718. We find supportive evidence for the managerial power hypothesis. Relative to low pay disparity firms, firms characterized by high pay disparity exhibit a significantly larger decline in options pre- versus post-expensing. Further, high pay disparity firms are found to replenish their compensation with cash-based rather than other equity-based pay. Our findings suggest CEOs in high pay disparity firms exploited the free accounting cost of options to inflate their pay rather than for their incentive properties.

Are CEOs Held Accountable for Unrecognized Expenses? The Case of Implied Employee Option Expense

An extensive body of research has investigated whether CEOs are held accountable for various earnings components by testing the sensitivity of CEO cash compensation to these earnings components. No study, however, has examined whether CEOs are held accountable for expenses unrecognized in earnings. This study investigates whether CEOs were held accountable for fair value employee stock option (ESO) expense in the period 1996-2005, during which the expense was not recognized, but rather implied by pro forma earnings disclosed in the footnotes under SFAS No. 123. Controlling for CEO stock option grants and other variables, I find that CEO cash compensation decreased with implied fair value ESO expense in the second half of the period 1996-2005 but not in the first half. The result represents the first evidence that CEOs can be held accountable for unrecognized expenses and how boards of directors view an unrecognized expense may be influenced by public opinions (accounting for fair value ESO expense was hotly debated in late 1990s and early 2000s). In high-tech industries, however, the result is very different. In these industries, CEO cash compensation was related to fair value ESO expense in neither the first half nor the second half of the period 1996-2005. The result is unsurprising given the strong position taken publicly by high-tech industry leaders that fair value ESO expense is not an expense to the firm and cannot be measured accurately.

Limited Attention to Detail: How Analysts' Valuations Change Following Mandatory Option Expensing

We show that financial analysts' valuations became less accurate and more pessimistic following a large drop in headline earnings that did not reveal new information about firm profitability. Regulation FAS 123-R required firms to begin expensing stock option compensation in the income statement, instead of disclosing costs only in financial statement footnotes. We test how this change in expense visibility affected analyst forecasts and stock recommendations. For identification, we exploit that FAS 123-R's compliance dates were staggered based on firms' fiscal year ends. Firms that began to expense options experienced larger analyst forecast errors and were one-third more likely to miss their consensus earnings forecast, relative to observationally similar firms that did not begin expensing options in the same year. Analysts also more often revised down their recommendations on these firms' stocks. As a result, affected firms experienced large drops in market value. Our results are consistent with the limited attention hypothesis that analysts and investors overvalue firms when value-relevant information is less accessible.

Executive Compensation Incentives Contingent on Long-Term Accounting Performance

Abstract The percentage of S&P 500 firms using multiyear accounting-based performance (MAP) incentives for CEOs increased from 16.5% in 1996 to 43.3% in 2008. The use and design of MAP incentives depend on the signal quality of accounting versus stock performance, shareholder horizons, strategic imperatives, and board independence. After the technology bubble, option expensing, and the publicity of option backdating, firms increasingly use stock-based MAP plans to replace options, resulting in changes in pay structure, but not in pay level. While firms respond to the evolving contracting environment, they consider firm characteristics and shareholder preferences and do not blindly follow the trend. Received September 20, 2013; accepted November 20, 2015 by Editor David Denis.

The causal effect of option pay on corporate risk management

This study provides strong evidence of a causal effect of risk-taking incentives provided by option compensation on corporate risk management. We utilize the passage of Financial Accounting Standard (FAS) 123R, which required firms to expense options, to investigate how chief executive officer option compensation affects the hedging behavior of oil and gas firms. Firms that did not expense options before FAS 123R significantly reduced option pay, which resulted in a large increase in their hedging intensity compared with firms that did not use options or expensed their options voluntarily prior to FAS 123R.