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Review of Accounting Studies

Erschienen in:

01.12.2006

Do firms understate stock option-based compensation expense disclosed under SFAS 123?

verfasst von: David Aboody, Mary E. Barth, Ron Kasznik

Erschienen in: Review of Accounting Studies | Ausgabe 4/2006

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Abstract

Focusing on the four key option pricing model inputs—expected option life, expected stock price volatility, expected dividend yield, and the risk-free interest rate for the expected life of the option—this study finds that firms understate option value estimates and, thus, stock-based compensation expense disclosed under SFAS 123. As predicted based on incentives and opportunities for management to understate SFAS 123 expense, the understatement of option value estimates is increasing in proxies for the magnitude of the expense, is greater for firms with weaker corporate governance, and, to a lesser extent, is increasing in the excessiveness of executive pay. The findings are strongest for the expected option life and expected stock price volatility input assumptions, consistent with firms’ greater latitude in determining these inputs. We find weaker evidence of understatement associated with the expected dividend yield assumption, and none for the interest rate assumption, consistent with these inputs being less amenable to discretion. Taken together, our findings raise some concern that the exercise of management discretion adversely affects the overall reliability of SFAS 123 expense.

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Since the summer of 2002, many firms have announced their intention to recognize SFAS 123 expense in determining net income. For analyses of factors associated with these firms’ decision to recognize SFAS 123 expense and the market reaction, see Aboody, Barth, and Kasznik (2004b). Our sample period predates these recognition announcements.

Although SFAS 123 expense depends on other assumptions, we focus on those related to disclosed option value estimates because there likely is less opportunity for management discretion relating to the others. In particular, the number of options granted, vesting period, and exercise price are contractual and, thus, observable at grant date, as is the grant date stock price. Also, granting fewer options, lengthening the vesting period, and increasing the exercise price have economic consequences for the firm beyond managing accounting amounts.

Reliability is one of the primary factors standard-setters consider in assessing accounting amounts (FASB, 1980). Reliability of accounting amounts has several dimensions (FASB, 1980). One is verifiability, i.e., the extent to which different measurers would arrive at the same amount, and another is neutrality, i.e., the amount is an unbiased measure of the object of measurement. These are the dimensions we focus on. That is, we take the measurement guidance in SFAS 123 as given and investigate how firms implement that guidance. Thus, the understatement to which we refer is relative to unbiased implementation of SFAS 123. A third dimension of reliability is representational faithfulness, i.e., the extent to which the amount represents what it purports to represent. Focusing on this dimension of reliability would require determining the best estimate of employee stock option values, which is beyond the scope of our inquiry.

Aboody, Barth, and Kasznik (2004a) provides evidence on the reliability of SFAS 123 expense using a capital markets-based research design. It concludes that SFAS 123 expense is reliable enough to be reflected in investors’ valuation assessments. ABK jointly tests reliability and relevance. The design does not permit determining the extent of reliability or identifying more or less reliable inputs.

Consistent with this view, S&P includes unrecognized expense from stock option grants in the calculation of “Core Earnings” in an attempt to provide a standard, comparable income number that most closely reflects the earnings from the firm’s ongoing operations (Business Week, May 27, 2002, pp. 34–37).

This belief of managers is summarized in the following quote: “If stock options aren’t a form of compensation, what are they? And if compensation isn’t an expense then what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?” (Warren Buffet, CEO of Berkshire Hathaway, Inc., 1994).

Although we are unaware of use of pro forma net income disclosed under SFAS 123 in explicit accounting-based contracts, the extent to which pro forma net income affects implicit contracts is an open question.

The only exception is the treatment of expected forfeitures. SFAS 123 expense is adjusted during the vesting period for differences between expected and actual forfeitures. Thus, exercising discretion relating to expected forfeitures can alter the timing of SFAS 123 expense across periods within the vesting period. We do not consider discretion with respect to expected forfeitures because neither they nor whether the firm incorporates them are publicly disclosed and, therefore, available to us.

Lewellen, Park, and Ro (1995), Murphy (1996), Yermack (1998), and Baker (1999) find evidence consistent with firms understating in their proxy statements estimated values of options granted to the firm’s CEO, particularly when the CEO receives more compensation than predicted by compensation models.

There are numerous examples of excessive executive compensation attracting media attention and investor action. For example, Computer Associates International Inc. awarded more than $1 billion in stock to three top executives, of which $655 million was to Chairman and CEO Charles B. Wang, ranking him one of the highest-paid executives in 1999. As described in BusinessWeek (April 17, 2000), “the award prompted a dozen lawsuits and a barrage of criticism. Graef S. Crystal, the prominent executive-pay gadfly, lambasted the award as ‘unconscionable’ and described Wang as easily the most overpaid CEO in the history of the U.S.”

There is a large literature documenting that managers exercise financial reporting discretion and that equity values reflect some effects of such discretion (for a review of this literature, see Fields, Lys, & Vincent, 2001). Also, managers talk and act as if they believe financial statement users do not undo fully the effects of accounting discretion. Regardless of whether managers succeed in managing investors’ perceptions, extant studies (e.g., Barth & Hutton, 2004; Burgstahler & Dichev, 1997; Sloan, 1996; Xie, 2001) assume they attempt to do so.

We estimate all equations using a robust regression technique, pooling data across years. The procedure begins by calculating Cook’s D statistic and excluding observations with D > 1. Then, the regression is re-estimated, weights for each observation are calculated based on absolute residuals—Huber weights and biweights—and the estimation is repeated iteratively using the weighted observations until convergence in the maximum change in weights is achieved (Berk, 1990). Our significance tests are based on standard errors calculated using the pseudo values approach described in Street, Carroll, and Ruppert (1988), after adjusting them to be heteroskedasticity-consistent (White, 1980). Our inferences are unaffected by using ordinary least squares estimation.

We use an indicator variable for GOV because we have no reason to believe that all of the governance provisions comprising it affect governance equally. For example, we have no reason to believe that the effect on governance of the firm having 5 provisions rather than 2 is the same as having 23 provisions rather than 20. Nonetheless, untabulated findings reveal that none of our inferences is affected by defining GOV as the number of governance provisions.

We presume that option cancellations reflect option forfeitures prior to vesting. Although such forfeitures do not directly affect expected option life, they suggest the level of employee turnover. Cancellations also could reflect expiration of out-of-the-money vested options. Thus, in a sensitivity analysis we include the ratio of current share price to the average exercise price of cancelled options as an explanatory variable and interacted with option cancellations. Untabulated findings reveal that the negative relation we document between LIFE and option cancellations is not attributable to out-of-the-money options.

Untabulated findings reveal that all four variables are significantly associated with LIFE, with signs consistent with expectations. The t-statistics are 7.39 for vesting period, − 11.17 for the fraction of cancelled options, − 10.94 for the fraction of exercised options, and 2.14 for the percent of options granted to the top five executives. The estimation equation also controls for industry and year effects. The adjusted R ² is 15.6%.

OPT_OUT is not an incentive variable because although SFAS 123 expense includes option value estimates associated with option grants in prior years, SFAS 123 requires the expense to be based on grant-date option values. The expense is not adjusted for subsequent changes in option values. Thus, any discretion exercised by firms in determining the inputs in any particular year affect only the estimated values of options granted during that year. Estimated values of options granted in prior years do not change. Untabulated findings reveal that our inferences are identical when we omit OPT_OUT from Eqs. 1 and 2a–d.

Huddart and Lang (1996) and Core and Guay (2001) find that recent stock performance is significantly related to employees’ early option exercises. The focus of these studies is on explaining ex post exercise patterns. In contrast, we seek to explain firms’ ex ante assumptions relating to expected option lives.

Untabulated findings reveal that all three volatility measures are incrementally significantly positively related to VOL. In particular, the coefficients (t-statistics) from a regression of VOL on VOL_HIST, 1YR_VOL^PRE, and 1YR_VOL^POST are 0.67, 0.14, and 0.08 (50.32, 12.01, and 9.68). Ideally, we would include realized future volatility for a subsequent period equal to expected option life. However, because our sample period ends in 2001, we are unable to do so. Expected future volatility can also be approximated using estimates of implied volatilities inferred from the prices of traded call options (see Bartov, Mohanram, & Nissim, 2004). However, publicly traded options generally have much shorter horizons than employee stock options, and are not available for many of our sample firms.

Untabulated findings reveal that our inferences relating to COMPX, RESCOMP, and GOV from Eqs. 1 and 2a–d are identical when we exclude the control variables. Untabulated findings also reveal that our inferences from Eqs. 1, 2a, c, and d are identical when we include all of the control variables. We do not include LIFE_PRED or LIFE in Eq. 2a and DIV_HIST in Eq. 2c because LIFE and DIV are the variables of interest in these equations. The tabulated specification of Eq. 2b includes all control variables.

Firms in the S&P 500 index are noticeably larger than those in the other two indices. However, our inferences are unaffected if we estimate our equations separately for firms in the S&P 500 index and in the other two indices.

The term significant denotes statistical significance at less than the 5% level, using a one-sided test for signed predictions and a two-sided test otherwise.

The limited discretion in SFAS 123 relating to the interest rate assumption might lead one to expect a higher correlation between INT and INT_HIST. However, firms base INT on the interest rate prevailing at grant date. Because we do not have access to grant dates, we base INT_HIST on average rates over the grant year. This difference introduces noise in INT_HIST. For example, the means of the risk-free rate for each year in our sample period, assuming a 5-year expected life, range from 4.55% to 6.22%. The standard deviations range from 0.37% to 0.54%, which indicate substantial within-year variation in interest rates.

In Table 6, we restrict the sample to be the same as in Tables 3 and 4. However, those tables require availability of OPTVAL, which is not required in Table 6. When we estimate the Table 6 specifications using all available data (number of observations = 3,724), the untabulated findings are identical to those in Table 4, including the significant negative relation between LIFE and RESCOMP (t = −2.41).

Because assuming a higher dividend yield decreases option value, in the Table 6 estimation of the DIV regression we multiply the experimental variables, COMPX, RESCOMP, and GOV, by minus one.

Execucomp estimates the value of options granted to top executives by assuming, for all stock options, an expected life of 70% of contractual life, stock price volatility estimated over the past five years, dividend yield estimated over the past three years, and risk-free interest rate measured over the past seven years.

We do not include some proxies for human capital and agency conflicts that Baker (1999) and Core et al. (1999) use because of lack of data availability and our much larger sample. Our inferences are insensitive to including two of these proxies for which data are available, i.e., CEO tenure with the firm and CEO stock ownership. We use the logarithm of CEO_COMP and SALES because doing so is common practice in the compensation literature. Our findings are robust to using the variables without the logarithmic transformation.

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Titel: Do firms understate stock option-based compensation expense disclosed under SFAS 123?
verfasst von: David Aboody
Mary E. Barth
Ron Kasznik
Publikationsdatum: 01.12.2006
Verlag: Kluwer Academic Publishers-Plenum Publishers
Erschienen in: Review of Accounting Studies / Ausgabe 4/2006
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-006-9013-0

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