Stock Option Compensation Research Articles

Employee sentiment and stock option compensation

The use of equity-based compensation for rank-and-file employees is a puzzle. We analyze whether the popularity of option compensation may be driven by employee optimism, and show that optimism by itself is insufficient to make option compensation optimal. The crucial insight is that firms compete with financial markets as suppliers of equity to employees and that employees’ access to the equity market restricts firms’ ability to profit from employee optimism. Firms must be able to extract some of the implied rents even though employees can purchase company equity in the financial markets. Such rent extraction becomes feasible if employees prefer the stock options offered by firms to the equity offered by the market, or if the traded equity is overvalued. We provide empirical evidence that firms use broad-based option compensation when boundedly rational employees are likely to be excessively optimistic about company stock, and when employees are likely to strictly prefer options over stock.

The Effects Of Endowment And Loss Aversion In Managerial Stock Option Valuation

Assuming a positive influence of stock price volatility on stock option value, incentive alignment proponents argue that stock option compensation encourages managerial risk seeking and, thus, aligns managers' and shareholders' risk preferences. Our findings show that stock option holders overvalue unexercisable options relative to options being offered and to normative (e.g., Black-Scholes) valuations. Further, the influence of stock price volatility on holders' subjective valuations depends on stock price trend. In sum, results suggest that during stock option valuation, managers draw on heuristics that financial options theory and models fail to capture. We discuss implications for compensation design and research.

Executive Compensation in S&P500, S&Pmidcap and S&Psmallcap Listed Firms

This article analyzes the factors which explain executive compensation in S&P500, S&PMidCap and S&PSmallCap listed firms and the evolution of executive compensation values and components from year 1992 to 2005. Our results reveal that S&P500 executives received, on average, more than double the total compensation of S&PMidCap executives, and this difference is greater in the case of S&PSmallCap executives. If we analyze the compensation components, we can see that stock options are, on average, the most important component of compensation in S&P500, S&PMidCap and S&PSmallCap. Essentially after the Sarbanes-Oxley act in 2002, the average restricted stock options compensation value increases year after year in S&P500, S&PMidCap and S&PSmallCap and in year 2005 the average restricted stocks executive compensation value is very similar to average executive compensation value of stock options in all this three groups. In terms of the factors that explain the CEO and Directors compensation, we found that variables like ROA, executive stock ownership, CEO tenure, market value, sales increase in the last five years, the number of board meetings, and the number of stock options vested but not exercised are variables that explain executive compensation. We also found that the group of variables that explains CEOs and directors compensation is not the same when we analyse executives from S&P500 with executives from S&PMidCap and S&PSmallCap. Also the coefficients are different, and generally this difference is statically significant.

Recognition versus Disclosure of Stock Option Compensation: An Analysis of Judgements and Decisions of Nonprofessional Investors*/CONSTATER OU PRÉSENTER PAR VOIE DE NOTE LA RÉMUNÉRATION SOUS FORME D'OPTIONS D'ACHAT D'ACTIONS: UNE ANALYSE DES JUGEMENTS ET DES DÉCISIONS DES INVESTISSEURS NON PROFESSIONNELS

ABSTRACTGiven the importance of stock options in the aggregate compensation of chief executive officers and other firm employees in the 1990s and early 2000s, the International Accounting Standards Board issued an International Financial Reporting Standard on stock‐based payments on February 19, 2004, requiring that all share‐based payment transactions be recognized at fair value in entities' financial statements. The Canadian Institute of Chartered Accountants' Accounting Standards Board had already agreed to this principle and amended section 3870 of the CICA Handbook (stock‐based compensation) for financial periods beginning on or after January 1, 2004, making Canada the first major jurisdiction to require all public companies to expense employee stock‐based compensation awards. The revised section eliminated the possibility of disclosing pro forma net income and earnings per share only by way of a note.This research, conducted as a between‐subjects experiment with executive MBA students as nonprofessional investors, examines whether changes in the way stock option compensation is reported (recognition as an expense in the income statement or note disclosure of pro forma net income and earnings per share) affect financial statement users' judgements and investment decisions. Our results indicate that, consistent with the functional fixation hypothesis, the reporting method does indeed significantly influence subjects' judgement of the expected stock price direction, but has no material influence on their investment decisions.

(The Effect of Executive Compensation on Managerial Decision Makings in Banking Industry)

Korean Abstract: 본 연구는 경영자 스톡옵션과 보유주식 등 경영자 부의 델타 및 베가와 스톡옵션보상의 비중을 직접 측정한 후, 이들과 은행의 경영정책과 연관성을 검토함으로써 경영자 보상구조의 영향을 구체적으로 분석한다. 은행의 영업정책 변수로는 파생상품보유액 및 파생상품거래량, 예대율 및 예대마진율을 사용하며, 재무정책 변수로는 BIS 비율과 총부채비율을 사용한다. 분석결과에 의하면, 델타 및 베가와 스톡옵션보상의 비중이 파생상품보유액 및 거래량, 예대율 및 예대마진율, 그리고 BIS 비율과는 양( )의 상관관계를 가지며, 총부채비율과는 음(-)의 상관관계가 있음을 보여준다. 이는 주가 및 주가변동성에 대한 경영자 부의 민감도가 높을수록 그리고 경영자보상에서 스톡옵션이 차지하는 비중이 클수록 은행은 수익원 확대를 위해 적극적이며, 수익성을 높이기 위해 공격적으로 되며, 레버리지를 낮춤으로써 자기자본에 충실을 기하려는 유인을 가지게 된다는 것을 보여준다. 이 결과들은 스톡옵션 등 경영자 보상구조가 은행의 경영정책에 전반적으로 유의한 영향을 미치고 있다는 것을 보여주며, 또한 현재 국내은행 경영진에게 부여된 주가연계형 보상구조는 부채비율 증대나 위험자산 증대 등을 초래할 정도의 과도한 수준은 아니라는 것을 암시한다고 해석될 수 있다. English Abstract: We investigate how the executive compensation scheme affects managerial decision makings in banking industry. The wealth sensitivity of executive compensation scheme is measured by delta (wealth-to- performance sensitivity), vega (wealth-to-volatility sensitivity) of managers' wealth, and the relative size of stock option compensation. For business policy variables, we choose derivative holdings and trading, loan-deposit ratio and margin, For financial policy variables, we choose BIS ratio and leverage ratio. Our empirical results show that delta, vega, and the relative size of stock option compensation are positively related to derivative holdings and trading, loan-deposit ratio and margin, and BIS ratio, but are negatively related to leverage ratio. These results imply that banks whose compensation schemes are more sensitive to stock price and volatility are not only more inclined to actively diversify income sources and to increase profitability, but they are also more devoted to maintaining adequate level of capital by lowering leverage. Our findings suggest that the equity-based compensation such as stock options has a significant effect on managerial decision makings in banking industry and that the current compensation scheme is not too excessive to lead bank managers to higher level of leverage and preference to risky assets.

The Determinants of Stock Option Compensation: Evidence from Finland

A new, long, and rich panel data set consisting of all Finnish publicly traded firms is used to study how firm characteristics and stock market developments influence the adoption and targeting of stock option compensation. Stock option adoption is found to be a procyclical phenomenon. Findings from firm‐level econometric analysis often corroborate those based on U.S. data, but important differences also emerge. Findings include: (i) firms with higher market value per employee are more likely to use stock option compensation; (ii) share returns from the past year affect the adoption of targeted stock options, but not broad‐based plans; (iii) our results are consistent with the hypothesis that selective and broad‐based plans arise as solutions to differing monitoring difficulties. Broad‐based schemes are observed when production is human capital‐intensive and employee performance is hard to monitor, while selective schemes are adopted when ownership is dispersed and therefore owners may have weak incentives to monitor management.

Stock option compensation and the likelihood of meeting analysts' quarterly earnings targets

One role of stock options in executive compensation packages is to counterbalance the inherently short-term orientation of base salary and annual bonuses. Managerial compensation plans frequently include stock options in order to better align the interests of managers and outside shareholders and reduce agency problems. However, since option values are sensitive to fluctuations in stock prices, and investors reward firms that meet or exceed earnings expectations, executives of firms with sizable option components in their compensation plans have increased incentives to report earnings that meet or exceed analysts' forecasts. We show that the propensity to meet or exceed analysts' quarterly earnings forecasts is positively related to the use of options in top executives' compensation plans. Further, firms that employ relatively more options in their compensation plans more frequently report earnings surprises that exceed analysts' forecast by small amounts (between 0 and 1 cent per share). These results suggest that the use of stock-based compensation intensifies top executives' focus on financial analysts' short-term earnings forecasts.

Do Management Disavowals of Mandated Employee Stock Option Disclosures Affect Financial Report User Judgments and Decisions?

In this study we report the results of an experiment that examines how relatively sophisticated financial statement users interpret management stock option compensation disclosures under SFAS No. 123 and SFAS No. 123R. We predict and find that mandated income statement recognition, as required under SFAS No. 123R, leads to higher user assessments of reliability than either voluntary income statement recognition or voluntary footnote disclosure, options allowed under SFAS No. 123. Users view voluntary footnote disclosure as the least reliable reporting alternative. We also examine the amount users invest in response to these accounting treatments, and find that users invest more in a firm when management chooses income statement recognition than when management chooses footnote disclosure. We find no difference in investment amounts between mandated recognition and either voluntary recognition or footnote disclosure. Finally, although we find that these results are insensitive to whether management explicitly disavows the reliability of stock option expense, we present evidence that in side-by-side comparisons, where one firm disavows and the other does not, disavowals may affect user judgments and decisions.

CEO Stock Options and Equity Risk Incentives

Abstract: We test the hypothesis that the risk incentive effects of CEO stock option grants motivate managers to take on more risk than they would otherwise. Using a sample of mergers we document that the ratio of post‐ to pre‐merger stock return variance is positively related to the risk incentive effect of CEO stock option compensation but this relationship is conditioned on firm size, with firm size having a moderating effect on the risk incentive effect of stock options. Using a broader time‐series cross‐sectional sample of firms we find a strong positive relationship between CEO risk incentive embedded in the stock options and subsequent equity return volatility. As in the case of the merger sample, this relationship is stronger for smaller firms.

The Early Adoption of Stock Option Compensation Expense

I examine the likelihood of firms adopting the fair value based method of accounting for stock option compensation cost in 2002 and 2003. To examine this issue, I use two matched sample methodologies: (1) a size and book-to-market matching method typically employed in empirical accounting and finance research; and (2) a Propensity Score matching method typically used in the life sciences. I create a profile of firms that elected to expense employee stock option compensation when it was not yet required by Statement on Financial Standards No. 123 (Revised): Share-Based Payment (SFAS 123(R)). I find support for the general hypothesis that increasing switching costs from disclosure to recognition lowers the likelihood for stock option expense adoption in 2002 and 2003. More specifically, the likelihood of expensing stock options decreases when the magnitude of (implied) stock option expense increases and the value of options awarded to the firm's executives increases in relation to their total compensation. I find that the likelihood of expensing stock options increases when the interest coverage ratio increases and when the number of options awarded to the firm's executives increases in relation to the number of stock options awarded to all employees. I also find weak evidence that the likelihood of expensing is highest in the healthcare industry. Although these results hold under both matched sample approaches, the Propensity Score approach helps to prevent misleading statistical inference by reducing the bias inherent in traditional size and book-to-market matched sampling.

ACCOUNTING FOR EMPLOYEE STOCK OPTIONS AND MANDATORY EXPENSING: AN ECONOMICS PERSPECTIVE

Whether employee stock options should be expensed at the grant date has been a highly controversial accounting issue. While the existing literature draws pro-expensing conclusions based on accounting principles and analogies, we shed new light to the issue by examine three functions of option granting in an analytical model. In principle, we show that while expensing is justified for financing options granted for expense postponement, it would misrepresent incentive options granted for long-term performance improvement. In practice, we show that options' fair value or the cost of granting them may not be the right amount to expense, and the inherent risk-sharing function of employee stock options poses a fundamental difficulty in estimating their fair value based on option pricing models. In conclusion, the findings of our examination do not support mandatory option expensing.

FINANCIAL MISREPRESENTATION, EXECUTIVE COMPENSATION, AND FIRM PERFORMANCE: AN EMPIRICAL STUDY.

Financial misrepresentation is a grave, yet prevalent form of corporate misconduct. With its self-evident detrimental consequences of both an economic and social nature, misrepresentation is an organizational action that begs further study. We observe that this form of misconduct is influenced by both behavioral and agency forces. Using a matched sample design, we find that firms with performance below their industry's average performance, firms with performance significantly above their own past performance, or firms whose CEOs have high proportions of stock option compensation are more likely to misrepresent their financial position than other firms.

Understanding the rise and fall of stock options compensation: Taking principal–agent conflicts to the institutional (battle)field

Researchers that have used agency theory predictions of monitoring and incentive alignment that focus solely on principal–agent relationships at the organizational level have been unable to rationalize the use and design of stock options within organizations. In the early 1990s, stock options were virtually free, but eventually, organizations were required to disclose the value of the options in the footnotes of their financial statements. This imperative ignited a battle between agents (and their advocates) who opposed the formal accounting of options and shareholders (and their advocates) who changed their opinions about options over time. In this article, we develop a model to explain how the varying pressures across the various stages of institutionalization cannot only explain how principals and agents are influenced by the institutional environment in making options compensation decisions, but also when and how these parties will shape institutional contexts at the field level to encourage, perpetuate, or delegitimate the stock option arrangements that these actors prefer.

Employee Sentiment and Stock Option Compensation

The use of equity-based compensation for employees in the lower ranks of large organizations is a puzzle for standard economic theory: undiversified employees should discount company equity heavily, and any positive incentive effects should be diminished by free rider problems. We analyze whether the popularity of option compensation for rank and file employees may be driven by employee optimism. We develop a model of optimal compensation policy for a firm faced with employees with positive or negative sentiment, and explicitly take into account that current and potential employees are able to purchase equity in the firm through the stock market. We show that employee optimism by itself is insufficient to make equity compensation optimal for the firm. Any behavioral explanation for equity compensation based on employee optimism requires two ingredients: first, employees need be over-optimistic about firm value, and second, firms must be able to extract part of the implied rents even though employees can purchase company equity in the market. Such rent extraction becomes feasible if employees prefer the non-traded compensation options offered by firms to the traded equity offered by the market, or if the traded equity is overvalued. We then provide empirical evidence confirming that firms use broad-based option compensation when boundedly rational employees are likely to be excessively optimistic about company stock, and when employees are likely to have a strict preference for options over stock.

Expensing stock-based payments: A material concern?

Using SFAS 123 disclosures, Botosan and Plumlee [Botosan, C., & Plumlee, M. (2001). Stock option expense: The sword of Damocles Revealed. Accounting Horizons, 15, 311–327] find that if stock-based compensation were to be expensed rather than not recognised on the face of financial statements, the impact on key measures used to assess the performance of the fastest growing US firms would be material. Street and Cereola [Street, D. L., & Cereola, S. (2004). Stock option compensation: impact of expense recognition on performance indicators of non-domestic companies listed in the U.S. Journal of International Accounting, Auditing and Taxation, 13, 21–37] subsequently also use SFAS 123 disclosures to determine that the average impact of expensing stock-based compensation on diluted EPS for non-US domiciled firms listed on US exchanges will be material and approximately 40%. In this paper, we examine whether these findings apply across international borders to firms that are required from 2005 to adopt IFRS 2 Share-Based Payment to expense stock-based payments, and across a broad range of industries and firms’ growth phases. Based on Australian Stock Exchange-listed firms’ 2002 stock-based compensation disclosures of the value of options granted to directors and the top 5 executives, the expensing of options will have a significant negative effect on approximately 20% of our sample firms’ financial performance ratios. It appears that the materiality of the impact is neither industry specific nor restricted to high growth firms. As the IFRS 2 expensing requirement extends to stock-based compensation issued to all employees, our findings are conservative estimates of the impact. The findings suggest that a stock-based compensation accounting policy change will affect recognised financial numbers and could have consequential ramifications for contractual specifications and valuations of firms across a range of industries and growth phases. Our sample of Australian firms provides an interesting context for the study, since these firms have neither traditionally expensed nor necessarily disclosed stock-based payments but from 2005, all stock-exchange listed Australian firms will be at the forefront of IFRS 2 adoption.

Stock Option Compensation and Managerial Discretion in the Insurance Industry: Are Reserves Manipulated to Enhance Profitability?

Stock options create an incentive for managers of companies to maximize the value of their company's stock. Prior research has hypothesized that managers of insurers manipulate reserve levels to achieve organization goals, including minimization of taxes and income smoothing. The current study tests whether the awarding of stock options to insurance company executives is associated with the accuracy of reserve estimates. We test two competing hypotheses. The first hypothesis is that the granting of options to executives encourages under reserving. This would be the case if inflated earnings resulting from under reserving result in higher insurer stock valuations. The second hypothesis is that grants of options to executives result in more accurate reserving. Empirical support for this hypothesis would suggest the market valuations of insurers' stock take into consideration the perceived accuracy of financial disclosures and that valuations are higher for firms that report more accurate reserve estimates. Consequently, executives holding options will attempt to report reserve estimates as accurately as possible. Our empirical analyses support the hypothesis that insurers that award stock options estimate reserves more accurately than other insurers, other things equal.

Besteuerung von Aktienoptionsprogrammen für Mitarbeiter bei Einkommensteuerprogression

This paper investigates the effects of taxes on the optimal timing of the taxation of stock option compensation for managers and employees. It is shown that the taxation of the fair market value at grant can be both advantageous or disadvantageous for managers and employees compared to the taxation of realized gains at exercise. Results are heavily dependent on assumed risk preferences and tax progression. In most instances, risk averse actors would prefer the taxation of realized gains at exercise. Another result is that taxation of the fair market value at grant tends to reduce the holding period leading to rational early exercise by risk averse actors. Since this behaviour tends to reduce option value, taxation of fair market value based on time to maturity instead of time to exercise can lead to extremely high real tax rates which may exceed 100%. This result suggests that taxation of realized gains is more appropriate since problems of measuring individual risk preferences or applying an unduly high real tax rate are avoided. Furthermore, at grant taxation may result in employees reluctant to take part in stock option plans. Therefore, a tax system with at grant taxation is more likely to affect behaviour adversely than is a system with an exercise tax.

Stock option compensation: impact of expense recognition on performance indicators of non-domestic companies listed in the U.S.

The IFRS 2, Share-based Payment, requires that companies recognize the fair value of employee stock options as an expense. To ascertain the impact recognition will have on companies domiciled in countries subject to accounting standards issued by the IASB’s liaison standard setting partners, this research examines the pro forma stock option disclosures provided in Form 20-F by Australian, British, Canadian, French, German, Japanese, and Irish companies. The findings indicate the average impact of expense recognition on diluted EPS will be approximately 40% and will be material at a 5% level for the majority of the companies. The impact varies significantly by country. On average the annual expense recognized will be approximately 15% of beginning stockholders equity. For the majority of the companies, the charge will represent less than 1% of beginning equity. Again the impact varies significantly by country. The findings indicate that absent requirements that stock compensation expense be recognized, a material upward bias will be reflected in performance indicators of many non-U.S. companies and cross-border comparability will be impaired. Since our analysis is based solely on data for the year 2000 for companies domiciled in seven countries, future research will be needed to ascertain the impact of expense recognition on a broader range of companies reporting under IFRS 2.

The Evolution of Stock Option Accounting: Disclosure, Voluntary Recognition, Mandated Recognition, and Management Disavowals

In this study we report the results of an experiment that examines how relatively sophisticated financial statement users interpret management stock option compensation disclosures under SFAS No. 123 and SFAS No. 123R. We predict and find that mandated income statement recognition, as required under SFAS No. 123R, leads to higher user assessments of reliability than either voluntary income statement recognition or voluntary footnote disclosure, options allowed under SFAS No. 123. Users view voluntary footnote disclosure as the least reliable reporting alternative. We also examine the amount users invest in response to these accounting treatments, and find that users invest more in a firm when management chooses income statement recognition than when management chooses footnote disclosure. We find no difference in investment amounts between mandated recognition and either voluntary recognition or footnote disclosure. Finally, although we find that these results are insensitive to whether management explicitly disavows the reliability of stock option expense, we present evidence that, in side-by-side comparisons, where one firm disavows and the other does not, disavowals may affect user judgments and decisions.

Stock option compensation: impact of expense recognition on performance indicators of non-domestic companies listed in the U.S.

The IFRS 2, Share-based Payment, requires that companies recognize the fair value of employee stock options as an expense. To ascertain the impact recognition will have on companies domiciled in countries subject to accounting standards issued by the IASB’s liaison standard setting partners, this research examines the pro forma stock option disclosures provided in Form 20-F by Australian, British, Canadian, French, German, Japanese, and Irish companies. The findings indicate the average impact of expense recognition on diluted EPS will be approximately 40% and will be material at a 5% level for the majority of the companies. The impact varies significantly by country. On average the annual expense recognized will be approximately 15% of beginning stockholders equity. For the majority of the companies, the charge will represent less than 1% of beginning equity. Again the impact varies significantly by country. The findings indicate that absent requirements that stock compensation expense be recognized, a material upward bias will be reflected in performance indicators of many non-U.S. companies and cross-border comparability will be impaired. Since our analysis is based solely on data for the year 2000 for companies domiciled in seven countries, future research will be needed to ascertain the impact of expense recognition on a broader range of companies reporting under IFRS 2.