Stock Option Compensation Research Articles

Why Stock and Stock-Option Compensation are Such a Terrible Idea

Stock options have grown over the last decade to take up an increasing percentage of the increasing compensation of top management. Stock options worth millions of dollars are reported to public investors as if they were free, and that allows top management to schnooker more salary from shareholders than they would otherwise get. The popularity of options is best understood as arising from deceptive accounting. But for the opportunity to understate compensation cost, stock compensation is a terrible idea. Take away the accounting advantage and compensatory stock and stock options would undoubtedly die off on their own. First, stock options give management truly perverse incentives to invest in projects with too much downside risk. Option holders participate in gains but not loses, so an option holder will rationally send the company into risks that would scare the flesh off of shareholders who do bear the losses. Second, stock and stock options carry an unnecessarily high discount rate. The high discount rate means the executive gets the least current value per dollar to be paid or requires the highest future cash payment per dollar of current value or both. Stock carries a high discount rate because of unwelcome volatility in the price of the stock and because of market paranoia about management plans about retained earnings, and neither the volatility nor the paranoia is a necessary virtue of any compensation plan. Better management of the discount rate would avoid stock. Third, stock compensation, gives employees capital gains, but compensation would almost always be more efficient if employee capital gains were avoided. Deferred compensation is almost always better for the executive because it delays the tax bite on their capital. Even if there is no upfront tax on capital at stake, employee capital gain is usually inferior tax planning because it loses the employer deduction. This is an edited version of Stock and Stock-Option Compensation: A Bad Idea, 51 Canadian Tax J. No. 3, (Oct. 2003) with the special Canadian concerns deleted out.

Dot.com or Dot.bomb? The Unpleasant Tax Surprise of Stock Options in a Volatile Market

This case explores the tax treatment of employee stock options as well as associated tax- and financial-planning issues. The number of employee stock option plans and related option grants has increased dramatically in the last decade. Today, senior management and rank-and-file workers alike often own substantial numbers of options and shares of employer stock acquired through the exercise of options. While these holdings can be valuable forms of compensation, exercising options also can be costly and risky. Early in 2000, following the stock market boom and its substantial decline later that same year, many employees who exercised options while the equity markets were at record highs were left with large tax bills. In some cases, the taxes owed exceeded the value of the optioned stock at year-end. This case details the tax and financial impact of option exercise on one employee that chose to retain optioned stock during the stock market crash of 2000. The educational objectives of the case include: (1) becoming familiar with the tax and financial aspects of compensatory stock options, (2) identifying the risks and rewards of option grant and exercise, (3) quantifying the cash inflows and outflows associated with stock options and their tax consequences, and (4) planning to maximize the after-tax value of stock option compensation. The case also discusses the tax treatment of options from the employer's perspective and the policy issues associated with tax deductions for option exercise.

Stock Option Compensation and Earnings Management Incentives

We examine whether the structure of executive compensation, specifically stock options relative to other forms of pay, is associated with opportunistic use of discretionary accruals in reported earnings. Prior research suggests that using options creates an incentive to temporarily depress the firm's stock price prior to the option award date, thereby lowering the exercise price of the options. We hypothesize, and find evidence, that relatively high option compensation is associated with income-decreasing discretionary accrual choices in periods leading up to option award dates. Furthermore, we find that this association is stronger when managers are able to publicly announce earnings prior to the option award date. Our results are consistent with the general implication from prior research that option compensation creates opportunistic incentives for managers to time the release of good and bad news to the market.

Discussion—Stock Option Compensation and Earnings Management Incentives

Discussion—Stock Option Compensation and Earnings Management Incentives

Large Sample Evidence on the Relation Between Stock Option Compensation and Risk Taking

A distinctive feature of stock options is that they create incentives for managers to take risks. For a sample of 6,439 CEO-year observations over 1992-1999, we find that risk-taking incentives offered by CEO's stock options (the sensitivity of ESO values to stock return volatility) are statistically associated with greater risk-taking behavior as proxied by one-year ahead stock return volatility. However, the economic magnitude of such option-induced risk taking on the CEO's wealth is relatively modest. Our tests of the performance consequences of option-induced risk taking incentives are specification-dependent and do not exhibit consistent results. Hence, we cannot unambiguously conclude that the increased risk taking results in improved future operating performance.

Applying the Ohlson and Feltham-Ohlson Models for Equity Valuation: Some Accounting Considerations

This paper is designed as a secondary research that summarizes major findings related to the equity valuation models of James Ohlson (1995) and Gerald Feltham & James Ohlson (1995) from the viewpoint of their application in real world circumstances and with only publicly available information at hand. The Ohlson model estimates the value if equity on the basis of its book value and the sum of all future abnormal earnings calculated from a clean-surplus income and a charge for the required return on the equity investment. The consequent Feltham-Ohlson model adjusts the valuation for the effects of conservative accounting practices on book values and earnings. The paper presents a case study of Microsoft Corporation, where the company is valued separately by both models and under different settings of the input data with the purpose to compare the extent to which the models deal with accounting distortions. The study focuses particularly on the impact of deviations from the clean-surplus principle and comments on other deficiencies in the publicly available accounting data. The Feltham-Ohlson model was found more suited to cope with such accounting problems, while the Ohlson valuation produced considerably understated estimates of common equity. The case study also indicated that deficiencies in the reporting of employee stock option compensation, investments and derivatives might produce major inconsistencies in the examined valuation frameworks and distort their results.

Does Search-Facilitating Technology Improve the Transparency of Financial Reporting?

XBRL (eXtensible Business Reporting Language) is an emerging technology that facilitates directed searches and simultaneous presentation of related financial statement and footnote information. We investigate whether using an XBRL-enhanced search engine helps nonprofessional financial statement users acquire and integrate related financial information when making an investment decision. We conduct our investigation in the context of recognition versus disclosure of stock option compensation. Our results reveal that many users do not access the technology, but those who do use it are better able to acquire and integrate information. Specifically, we find that when stock option accounting varies between firms, the use of an XBRL-enhanced search engine increases the likelihood that individuals acquire information about stock option compensation disclosed in the footnotes. We also find that XBRL helps individuals integrate the implications of this information, resulting in different investment decisions between individuals who use and do not use the search engine. Our results suggest that search-facilitating technologies, such as XBRL, aid financial statement users by improving the transparency of firms' financial statement information and managers' choices for reporting that information. Our results also reveal that wide publicity about the benefits of using search-facilitating technology may be needed to induce financial statement users to access the technology.

Post-Enron Reflections on Comparative Corporate Governance

In the heated debate of the last fifteen years over which of the world’s many different corporate governance systems are best, the shareholder primacy advocates thought they had won at the turn of the century. Now, in 2002, the helium has come out of the formerly high-flying technology and information infrastructure sectors that were leading the U.S. economic expansion in the 1990s, and the Enron fiasco and accounting scandals at numerous other U.S. corporations have exposed deep flaws in the system that had been held up as the model for all the world to follow. Many possible lessons can be drawn. At least one is that the high-powered incentives provided by stock option compensation may produce perverse behavior that can, in turn, undermine institutional arrangements that support and foster mutual trust and cooperation. The study of corporate governance must focus on more than just how to get management to maximize value for shareholders. It must also be about the human institutions that bind people together in cooperative relationship over long periods of time.

Managing Pro Forma Stock Option Expense under SFAS No. 123

We investigate whether footnote disclosures under Statement of Financial Accounting Standards (SFAS) No. 123 are managed in 1996, the first year that the disclosure was required. The 1996 phase-in of SFAS No. 123 provided firms with a unique opportunity to manipulate the pro forma disclosure in the initial years. SFAS No. 123 allows firms discretion in estimating the value of their stock option grants and in allocating that value across accounting periods. Although we find little evidence that firms manage the estimated value of their option grants, we find that firm-specific incentives affect how that value is allocated. Specifically, firms that provide high levels of either CEO compensation or stock option compensation relative to performance allocate a smaller proportion of the options' value to the 1996 pro forma expense, apparently to reduce criticism of that compensation. Small firms and firms that recently went public also allocate a smaller proportion of option value to the 1996 pro forma expense, apparently to increase perceptions of their profitability. We conjecture that firms were less likely to manage the value of the options granted than the allocation of that value in 1996 because the parameter estimates underlying the reported option value must be disclosed in the footnote, whereas the inputs to the allocation computation are not disclosed. These results, which suggest that firms manipulated pro forma stock option expense when their estimate choices cannot be observed, have implications for both standard setters and financial statement users. In particular, the FASB's current deliberations on the transition from footnote disclosure to income statement recognition for stock options should consider additional disclosures to minimize unobservable choices. More generally, the FASB may reduce potential manipulation by requiring expanded disclosures about the choices used in computing both pro forma and reported numbers.

Effective employee stock option design: Reconciling stakeholder, strategic, and motivational factors

Executive Overview When markets grew rapidly in the 1990s, many companies unquestioningly adopted employee stock options and implemented them at all levels within organizations. Recently, however, the corporate world has been described as suffering from an “overdose” of stock option compensation. We argue that more attention should be paid to the design of stock options to enhance their effectiveness. In support of this argument, we first review the upsides and downsides of stock options from recipient, company, and shareholder perspectives. Next, we identify conditions in which stock options can help a company implement a strategy and motivate key talent. We then provide guidelines for designing stock options, suggesting that managers must ask the following questions: Who should receive stock options? How many? What terms should be used? How often? At what price? What ownership? Careful consideration of these questions will lead to employee stock option compensation that promotes strategic goals; enables...

Estimating Damages Associated with Stock Option Compensation in Wrongful Termination Lawsuits

Abstract No abstract available.

Post-Enron Reflections on Comparative Corporate Governance

In the heated debate of the last fifteen years over which of the world's many different corporate governance systems were best, the shareholder primacy advocates thought they had won at the turn of the century. Now, in 2002, the helium has come out of the formerly high-flying technology and information infrastructure sectors that were leading the U.S. economic expansion in the 1990s, and the Enron fiasco and accounting scandals at numerous other U.S. corporations have exposed deep flaws in the system that had been held up as the model for all the world to follow. Many possible lessons can be drawn. At least one is that the high-powered incentives provided by stock option compensation may produce perverse behavior that can, in turn, undermine institutional arrangements that support and foster mutual trust and cooperation. The study of corporate governance must focus on more than just how to get management to maximize value for shareholders. It must also be about the human institutions that bind people together in cooperative relationships over long periods of time.

Empirical evidence on the relation between stock option compensation and risk taking

We examine whether executive stock options (ESOs) provide managers with incentives to invest in risky projects. For a sample of oil and gas producers, we examine whether the coefficient of variation of future cash flows from exploration activity (our proxy for exploration risk) increases with the sensitivity of the value of the CEO's options to stock return volatility (ESO risk incentives). Both ESO risk incentives and exploration risk are treated as endogenous variables by adopting a simultaneous equations approach. We find evidence that ESO risk incentives has a positive relation with future exploration risk taking. Additional tests indicate that ESO risk incentives exhibits a negative relation with oil price hedging in a system of equations where ESO risk incentives and hedging are allowed to be endogenously determined. Overall, our results are consistent with ESOs providing managers with incentives to mitigate risk-related incentive problems.

Empirical Evidence on the Relation Between Stock Option Compensation and Risk Taking

We examine whether executive stock options (ESO) encourage managers to make risky investments on behalf of shareholders. For a sample of oil and gas producers, we find, as predicted, that the variance of cash flows from exploration activity and the extent of price risk exposure hedged are positively associated with the sensitivity of CEO's options to equity risk. Thus, ESOs appear to motivate managers to take on exploration risk. Moreover, ESOs appear to induce CEOs to hedge oil price risk to avoid under-investment in exploration projects.

Stock options and managerial optimal contracts

In this paper we are concerned with the performance of stock option contracts in the provision of managerial incentives. In our simple framework, we restrict the space of contracts available to the principal to those conformed by a fixed payment and a package of call options on the firm's stock. We then offer a characterization of optimal stock option compensation schemes. As compared to the fixed payment and the option grant, we find that the strike price plays an intermediate role in the provision of insurance and incentives. We also develop some efficient algorithms for the computation of optimal contracts in which the observable outcome is drawn from a continuous distribution. These algorithms are useful to address some important issues such as the calibration of a principal-agent model, the degree of risk aversion compatible with current compensation schemes, and the performance of stock option contracts.

Stock option plans for non-executive employees

We examine determinants of non-executive employee stock option holdings, grants, and exercises for 756 firms during 1994–1997. We find that firms use greater stock option compensation when facing capital requirements and financing constraints. Our results are also consistent with firms using options to attract and retain certain types of employees as well as to create incentives to increase firm value. After controlling for economic determinants and stock returns, option exercises are greater (less) when the firm's stock price hits 52-week highs (lows), which confirms in a broad sample the psychological bias documented by Heath et al. (Quarterly Journal of Economics 114 (1999) 601–628).

Stock Options and Managerial Optimal Contracts

In this paper we are concerned with the performance of stock option contracts in the provision of managerial incentives. In our simple framework, we restrict the space of contracts available to the principal to those conformed by a fixed payment and a package of call options on the firm's stock. We then offer a characterization of optimal stock option compensation schemes. As compared to the fixed payment and the option grant, we find that the strike price plays an intermediate role in the provision of insurance and incentives. We also develop some efficient algorithms for the computation of optimal contracts in which the observable outcome is drawn from a continuous distribution. These algorithms are useful to address some important issues such as the calibration of a principal-agent model, the degree of risk aversion compatible with current compensation schemes, and the performance of stock option contracts.

Are Stock Options the Managers' Blessing? Stock Option Compensation and Institutional Controls

Stock option grants to top managers have largely contributed to the dramatic increase in US executive pay in recent years. In this paper it is argued that stock options, compared to other forms of compensation, have created strong incentives for managers to engage in lobbying activities for higher compensation. The empirical results presented for the S&P 500 firms and the years from 1992 to 1997 show that the relative success of such skimming activities is shaped by institutional controls. Stock option grants are substantially lower when control by the board of directors and the shareholders is higher, and competition on the product market of a firm is stronger.

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.

CEO stock option awards and the timing of corporate voluntary disclosures

We investigate whether CEOs manage the timing of their voluntary disclosures around stock option awards. We conjecture that CEOs manage investors’ expectations around award dates by delaying good news and rushing forward bad news. For a sample of 2,039 CEO option awards by 572 firms with fixed award schedules, we document changes in share prices and analyst earnings forecasts around option awards that are consistent with our conjecture. We also provide more direct evidence based on management earnings forecasts issued prior to award dates. Our findings suggest that CEOs make opportunistic voluntary disclosure decisions that maximize their stock option compensation.