Stock-based Compensation Research Articles

SFAS 123 Stock-Based Compensation Expense and Equity Market Values

The objective of this study is to understand the relation between equity market values and stock-based employee compensation expense that is disclosed, but not recognized in determining net income, under Statement of Financial Accounting Standards (SFAS) No. 123. In particular, we predict and find that stock-based compensation expense has a negative relation with share price, consistent with investors viewing it an expense of the firm. This finding calls into question the quality of reported earnings, because without recognition of stock-based compensation expense under SFAS 123, this expense is never included in the net income. It also indicates that stock-based compensation expense is measured with sufficient reliability to be reflected in investor's valuation assessments. Our tests focus on the relation between share price and stock-based compensation expense, after controlling for net income, book value of equity, and expected future earnings growth. Our findings are consistent with our predictions, indicating that investors view stock-based compensation expense as an expense of the firm, after controlling for reported net income, book value of equity, and expected future earnings growth.

Intellectual Capital, Monitoring and Risk: What Predicts the Adoption of Broad-based Employee Stock Options?

In this paper, we use empirical analysis to analyze company characteristics associated with the adoption and maintenance of broad-based stock option plans. First, a cross-sectional analysis evaluates what company characteristics are now associated with these plans. Second, a longitudinal analysis examines the company characteristics that predict the adoption of such plans. Overall, our results provide support to the claim that higher monitoring costs prompt firms to adopt and maintain employee stock option plans. Firms with higher levels of business risk are less likely to shift some of that risk to employees through stock-based compensation, whereas firm with higher variability in total shareholder returns are more likely to adopt broad-based employee stock options. Nonunion firms are more likely to adopt and maintain such plans, and financial constraints do not appear to be driving the adoption decision.

Employee Stock Options: Alternative Valuation Models

The Financial Accounting Standards Board (FASB) is considering modification of the method of accounting for employee stock options. It has tentatively decided that goods and services received in exchange for all forms of stock-based compensation should be recognized as an expense and that this expense should be measured at fair value. A major issue to be considered during the deliberations by the FASB concerns the valuation models used to estimate the fair value of stock options and therefore the expense to be recognized. This article reviews the current status of the valuation of employee stock options and suggests two different valuation models that result in lower reported expense on the income statement.

The Cost of Employee Stock Options

Employee stock options (ESOs) are nontransferable and employees are generally not well diversified compared to outside shareholders. These features of ESOs imply that employee option holders may optimally exercise their options significantly early relative to what would be expected for ordinary tradable options. Consequently, accounting for the cost of granting ESOs requires understanding how long employees hold the options. We use a unique database on observed option exercise patterns to document important characteristics of exercise behavior and how early exercise affects the cost of granting ESOs. We find that employees exercise their options nearly five years prior to expiration, and that there is significant predictable cross-sectional variation in exercise behavior. For example, employees in high volatility firms exercise their options more than a year and a half earlier compared to employees in firms with low volatility. We calibrate a utility-based model of option valuation to match the observed exercise behavior, and use the model to generate estimates of the cost of granting ESOs. Our estimates indicate that the cost of the option to the firm is significantly below the value of a tradable American option with a fixed 10-year (or 7-year) expiration. Importantly, we also find the bias is not uniform. Option values computed from the American valuation model with a fixed expiration overestimate the cost of ESOs more in high volatility firms compared to low volatility firms. In addition, adjusting the expiration to reflect the expected life of the option, as recommended by the FASB, still produces systematic biases in the option valuations. The FASB adjustment overstates the cost of granting ESOs in high volatility firms and understates the costs for low volatility firms, which is perhaps one reason that many technology-oriented companies (which are likely associated with high stock-price volatility) have been the most vocal in opposing the expensing of stock options. Our research suggests that modeling the exercise behavior of employees who hold stock options and how exercise patterns vary based on different firm and individual characteristics is important in understanding and accounting for the costs of granting stock-based compensation to employees.

CEO reputation and stock-based compensation

I develop a theory of stock-based compensation contracts for the chief executive officers (CEOs) of firms and confront the theoretical predictions with recent CEO compensation data. The model characterizes the optimal contract for a CEO whose reputation evolves as signals of the executive's ability are observed by shareholders. Using various proxies for CEO reputation, I show a positive and economically meaningful relationship between stock-based pay-sensitivities and CEO reputation. The findings are robust to controls for CEO age, firm size, the dollar variability of the stock returns, and industry effects.

Equity Incentives and Earnings Management

This paper examines the link between managers' equity incentives - arising from stock-based compensation and stock ownership - and earnings management. We hypothesize that managers with high equity incentives are more likely to sell shares in the future and this motivates these managers to engage in earnings management to increase the value of the shares to be sold. Using stock-based compensation and stock ownership data over the 1993-2000 time period, we document that managers with high equity incentives sell more shares in subsequent periods. As expected, we find that managers with high equity incentives are more likely to report earnings that meet or just beat analysts' forecasts. We also find that managers with consistently high equity incentives are less likely to report large positive earnings surprises. This finding is consistent with the wealth of these managers being more sensitive to future stock performance, which leads to increased reserving of current earnings to avoid future earnings disappointments. Collectively, our results indicate that equity incentives lead to incentives for earnings management.

The Dynamic Relation Between CEO Compensation and Earnings Management*

This study empirically examines both the form and the extent of earnings management and the possible endogeneity between earnings management and compensation. The results of the tests indicate that the total and mix of compensation are significant determinants of the extent and form of compensation. The evidence is consistent with managerial opportunism as managers smooth more (less) income as the bonus mix (stock-based compensation) increases (decreases). Also, the results provide strong evidence that CEOs have incentives to manage earnings to increase their total compensation and to maximize their bonus-based and stock-based compensation. This result provides an indication that earnings management behavior and compensation are dynamic and suggest the necessity to consider their endogenous nature in examining their relationship. The findings of this study should contribute to the academic research related to earnings management, compensation, and the usefulness of accounting numbers. Furthermore, the extent and form of earnings management related to compensation is important to accounting standard setters, regulators, investors, analysts, practitioners, and researchers because of the ongoing concern over earnings management.

Discussion of “Compensation policy and discretionary disclosure”

Nagar et al. (J. Accounting Econom. 34 (2003)) posits that stock-based compensation motivates managers to increase public disclosure of their private information. The hypothesis is intriguing and new to the literature, and the findings are consistent with it. However, developing the hypothesis depends on some unsupported assumptions and the link between the hypothesis and the empirical evidence is indirect, raising concerns about the validity of the study's inferences about the effects on disclosure of stock-based compensation.

Stock-based pay in new economy firms

Ittner, Lambert, and Larcker (J. Accounting Economics (2003) this issue) present compelling evidence that new economy firms rely more on stock-based compensation than do old economy firms, based on 1998 and 1999 data from a proprietary sample of companies. I complement the ILL results by analyzing data over a longer time period (1992–2001) and, more importantly, document the effect of the 2000 market crash on stock-based pay in new economy firms. Finally, I offer evidence supporting the conjecture that differences in pay practices between new and old economy firms reflect accounting considerations, perceived costs, and competitive inertia.

Discretionary disclosure and stock-based incentives

We examine the relation between managers’ disclosure activities and their stock price-based incentives. Managers are privy to information that investors demand and are reluctant to publicly disseminate it unless provided appropriate incentives. We argue that stock price-based incentives in the form of stock-based compensation and share ownership mitigate this disclosure agency problem. Consistent with this prediction, we find that firms’ disclosures, measured both by management earnings forecast frequency and analysts’ subjective ratings of disclosure practice, are positively related to the proportion of CEO compensation affected by stock price and the value of shares held by the CEO.

Stock price reaction and value relevance of recognition versus disclosure: the case of stock-based compensation

This study examines the equity price reaction to the pronouncements related to accounting for stock-based compensation and assesses the value relevance of recognition versus disclosure in financial reporting. We document that firms exhibit significant abnormal returns around the issuance of the Exposure Drafts proposing to require recognition of stock-based compensation costs, and also around the event reversing that decision to require disclosure only (while encouraging recognition). We also document that the abnormal returns are most pronounced for high-tech, high-growth, and start-up firms. Our results are consistent with the contracting theory, and show that disclosure is not a substitute for recognition.

Agency Problems are Ameliorated by Stock Market Liquidity: Monitoring, Information and the Use of Stock-Based Compensation

Recent theoretical models have shown that liquid stock markets can improve the alignment of managers' and shareholders' interests even though high stock turnover would seem to be incompatible with the traditional view of monitoring of management by a stable set of shareholders. We test the prediction of Holmstrom and Tirole (1993) that managers' compensation is more closely tied to shareholder wealth when the firm's shares trade more actively. It is strongly empirically supported using a sample of over 45,000 executive years and numerous tests. In virtually all specifications, the effect of liquidity is at least as great as that of size, risk, industry, year, the existence of growth options, leverage, the existence of cash constraints, firm focus, or the presence of government regulation, existing option holdings and stock holdings. In fact, utilizing 900 simulations across different sample sizes, three liquidity variables account for between 67% and 79% of the explained variation with the remainder accounted for by 17 traditional variables. By contrast, accounting-based bonus incentives are employed by more illiquid firms and have more the characteristics of a substitute rather than a complement. We conclude that boards delegate monitoring of executives to active market traders when the stock is liquid and undertake internal monitoring using bonus schemes when the stock is relatively illiquid. Given greater efficacy of external monitoring, this implies that stock market liquidity sets bounds on the size and complexity of diversified firms.

Corporate Lobbying Behaviour on Accounting for Stock‐Based Compensation: Venue and Format Choices

This article investigates U.S. corporate lobbying of the Financial Accounting Standards Board (FASB) in the U.S. on the exposure draft to Financial Accounting Standard No. 123 (FAS 123), Accounting for Stock‐Based Compensation. Essentially, firms lobbied the FASB in one of three ways: (a) against disclosure/recognition of any additional information beyond that already required in U.S. proxy statements, (b) for summary footnote disclosure of all employee stock‐based compensation (SBC), or (c) for either pro forma or formal income statement recognition of all employee SBC.This study finds that the higher the level of the SBC of the top five executives, the less likely firms are to favour disclosing that information. This finding supports the hypothesis that economic self‐interests motivated lobbying behaviour on FAS 123. Furthermore, the study finds that U.S. corporations lobby against disclosure of executive SBC in the annual reports even when the annual reports would disclose no additional information beyond that currently disclosed in proxy statements. This is evidence that managers perceive that the venue of disclosure (proxy versus annual report) matters. It is posited that managers lobbied against disclosure of SBC to avoid possible changes to compensation contracts which in turn could adversely affect stock prices. In sum, the results support the notion that managerial self‐interest affects lobbying behaviour on the venue as well as the format of disclosure.

Linking pay to performance—compensation proposals in the S&P 500

We study the proposal of manager-sponsored compensation plans linking pay to performance by S&P 500 firms in the 1990s. We examine the market perception of these proposals and the characteristics of the firms that propose them. Shareholders gain at the announcement of the plans, especially when the plans are directed toward the firm's top executives. Proposing firms are those that can most benefit from the plans, given their asset type and agency considerations. Firms with more potential agency costs have the highest vote-for percentages for the plans. However, shareholders are less approving of plans with negative features such as high dilution levels. Our work suggests that stock-based compensation plans are helpful in improving managerial efforts to increase shareholder wealth.

Executive Equity Compensation and Incentives: A Survey

Stock and option compensation and the level of managerial equity incentives are aspects of corporate governance that are especially controversial to shareholders, institutional activists, and governmental regulators. Similar to much of the corporate finance and corporate governance literature, research on stock-based compensation and incentives has generated not only useful insights, but also has produced many contradictory findings. Not surprisingly, many fundamental questions remain unanswered. In this article, the authors synthesize the broad literature on equity-based compensation and executive incentives, and highlight topics that seem especially appropriate for future research.

The Effect of Compensation Design and Corporate Governance on the Transparency of CEO Compensation Disclosures

We investigate the (i.e., the level of detail) of CEO compensation disclosures by Australian firms following regulatory changes in July 1998. After controlling for other possible economic determinants of disclosure, we find that transparency is negatively related to the level of size-adjusted compensation. We also find that transparency increases with firm size and (weakly) with performance. There is also evidence of a persuasion effect, in that disclosures made after the release of regulatory guidelines are more transparent. However, we find no evidence of specific corporate governance attributes (i.e., separation of the CEO and chair roles, auditor quality, board composition, the existence and structure of board committees) being associated with more transparent disclosures. Nor do we find any evidence of transparency being associated with the mix of cash and stock-based compensation. Although there is some indirect evidence of a negative relation between blockholder ownership and disclosure transparency, we find no significant relation with insider ownership. Overall, our results are consistent with corporate governance mechanisms having minimal impact on disclosure where there are potential conflicts of interest between the CEO and outside shareholders.

CEO compensation and bank mergers

Recent bank mergers generally did not improve relative operating performance or produce positive abnormal returns to acquiring bank shareholders. We examine the relationship between mergers and CEO compensation during 1986–1995, a period marked by overcapacity and frequent mergers. We find that mergers have a net positive effect on compensation, mainly via the effect of size on compensation. Compensation generally increases even if mergers cause the acquiring bank's stock price to decline, as is typical after a merger announcement. The form of compensation affects merger decisions, since CEOs with more stock-based compensation were less likely to make an acquisition.

Reciprocal and Non‐Reciprocal Transactions: The FASB’s Stock‐Based Compensation Project

Whether the FASB’s conceptual framework can be used to derive accounting treatments has been debated. Mozes (1998) argued that the conceptual framework’s high level of abstraction meant that several alternative views were possible for the treatment of stock‐based compensation and that this was unhelpful. This article identifies a problem at the abstract level of the conceptual framework that requires resolution before Mozes’ proposals to remedy the high level of abstraction may be acted upon—the inappropriateness of the conceptual framework’s distinction between liabilities and equity. The conceptual framework is clear that equity transactions are non‐reciprocal but the accounting treatment to be derived from this view is unacceptable and was not presented as an option in the stock‐based compensation project. Instead, the FASB’s basis for conclusions is based on reciprocal transactions, disguising the inappropriateness of the conceptual framework’s definitions. Failure to revise the conceptual framework leaves the FASB, and other standard‐setting bodies drawing on the FASB’s concepts, open to developing serious inconsistencies in other pro‐jects where the distinction between liabilities and equity is important, and without conceptual support for their stance on stock‐based compensation.

CEO Stock‐Based Compensation: An Empirical Analysis of Incentive‐Intensity, Relative Mix, and Economic Determinants

The use of stock-based compensation for U.S. CEOs has increased significantly throughout the 1990s. Research interest, in particular on stock option compensation, has similarly increased, yet contradictory results create questions about the theoretical underpinnings. Therefore, we revisit the controversy surrounding stock option awards, and we further the understanding of restricted stock grants, which have escaped similar research focus. Using a recent data set, we obtain convincing empirical support for most theoretical predictions about stock option awards. We also find that restricted stock, due to its linear payoffs, is relatively inefficient in inducing risk-averse CEOs to accept risky, value-increasing investment projects. Copyright 2000 by University of Chicago Press.

The Valuation Implications of Employee Stock Option Accounting for Computer Software Firms

In this study we compare the ability of alternative accounting methods for employee stock options (ESOs) to reflect firm value using the Ohlson [1995, 1999] and Feltham-Ohlson [1999] valuation models for a sample of 85 computer software firms. The three methods we compare are APB 25, ESO expense recognition based on SFAS 123 disclosures, and asset recognition at grant date based on the Exposure Draft: Accounting for Stock-Based Compensation. We estimate abnormal earnings forecasting and valuation equations for each accounting method. Findings suggest that the method of recognition of an asset at grant date best reflects the market?s valuation of ESO transactions. A robustness test indicates the asset may have a useful life longer than the option vesting period. An additional robustness test indicates that findings are not the result of endogeneity bias.