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Abstract:
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. However, not surprisingly, many fundamental questions remain to be answered. In this survey, we synthesize the broad literature on equity compensation and executive incentives, and highlight topics that seem especially appropriate for future research.

Executive compensation; Stock options; Equity incentives; Corporate governance

Abstract:
Previous research offers little large-sample evidence on the magnitude of non-financial firms' risk exposure hedged by financial derivatives. Among 234 large non-financial derivatives users, if the median firm simultaneously experiences a three standard deviation change in interest rates, currency exchange rates, and commodity prices, its entire derivatives portfolio will generate, at most, $15 million in current cash flow and will rise in value by $31 million. These amounts are modest relative to firm size, operating cash flows, investing cash flows and other firm benchmarks. The findings indicate corporate derivatives use is a small piece of non-financial firms' overall risk profile, and suggest the need to rethink some empirical research documenting the economic importance of firms' derivative use.

risk management, derivatives instruments, hedging

Abstract:
Previous research offers little large-sample evidence on the magnitude of non-financial firms' risk exposure hedged by financial derivatives. Among 234 large non-financial derivatives users, if the median firm simultaneously experiences a three standard deviation change in interest rates, currency exchange rates, and commodity prices, its entire derivatives portfolio will generate, at most, $15 million in current cash flow and will rise in value by $31 million. These amounts are modest relative to firm size, operating cash flows, investing cash flows and other firm benchmarks. The findings indicate corporate derivatives use is a small piece of non-financial firms' overall risk profile, and suggest the need to rethink some empirical research documenting the economic importance of firms' derivative use.

derivatives, hedging, risk management, risk exposure

Abstract:
If a firm's derivative positions generate positive cash flows or value in periods of economic adversity, then those derivatives are deemed to hedge the firm's risk. Previous research offers little large-sample evidence on the magnitude of non-financial firms' risk exposure hedged by the financial derivatives. In a sample of 234 large corporations that use derivatives, we find that if the median firm simultaneously experiences a three standard deviation change in interest rates, currency exchange rates, and commodity prices, it will collect $15 million of cash from its entire derivatives portfolio and that the entire derivatives portfolio will rise in value by $31 million. These dollar amounts are modest relative to firm size, operating cash flows, investing cash flows and other firm benchmarks. The findings raise questions about the role of derivatives securities held by non-financial firms.

Derivatives; Hedging; Risk management; Exposure

Abstract:
We find mixed support for the hypothesis that a "New Economy" subperiod occurred in the late 1990s in which the relation between equity value and traditional financial variables differs from previous periods. We examine a regression model of equity value on financial variables over 25 years for a broad firm sample and for firm subsamples thought to be emblematic of the New Economy. We find the regression model's explanatory power declined in the New Economy subperiod for all firm subsamples. However, for all subsamples, the regression model's structure during the New Economy subperiod is not unusual compared to other subperiods.

capital markets, equity valuation, New Economy

Abstract:
The acceleration of globalization combined with rapid advances in technology and the growing importance of the Internet have led many researchers and practitioners to suggest that a "New Economy" has evolved in which equity valuation is different than in previous periods. We examine the explanatory power and stability of a regression model of equity value on traditional financial variables for a broad sample of firms over the past 25 years and investigate how equity valuation has changed in the recent New Economy sub-period. We also examine subsamples of high-technology firms, young firms, and young firms with losses that are thought to be emblematic of the New Economy. We find that the explanatory power of the regression model declined in recent years for all subsamples of firms. However, for all subsamples of firms, we find that the structure of the regression model is quite stable during the New Economy sub-period, as compared to other sub-periods. Together, these results suggest that traditional explanatory variables of equity value remain applicable to firms in the New Economy sub-period, but that there is greater variation remaining to be explained by uncorrelated omitted factors.

Abstract:
The costs associated with compiling data on employee stock
option portfolios is a substantial obstacle in investigating
the impact of stock options on managerial incentives,
accounting choice, financing decisions, and the valuation of
equity. We present an accurate method of estimating option
portfolio value and the sensitivities of option portfolio
value to stock price and stock-return volatility that is
easily implemented using data from only the current year's
proxy statement or annual report. This method can be applied
to either executive stock option portfolios or to firm-wide
option plans. In broad samples of actual and simulated CEO
option portfolios, we show that these proxies capture more
than 99% of the variation in option portfolio value and
sensitivities. Sensitivity analysis indicates that the degree
of bias in these proxies varies with option portfolio
characteristics, and is most severe in samples of CEOs
with a large proportion of out-of-the-money options. However,
the proxies' explanatory power remains above 95% in all
subsamples.

Employee stock options; Incentives; Executive compensation

Abstract:
The costs associated with compiling data on employee stock option portfolios is a substantial obstacle in investigating the impact of stock options on managerial incentives, accounting choice, financing decisions, and the valuation of equity. We present an accurate method of estimating option portfolio value and the sensitivities of option portfolio value to stock price and stock-return volatility that is easily implemented using data from only the current year?s proxy statement or annual report. This method can be applied to either executive stock option portfolios or to firm-wide option plans. In broad samples of actual and simulated CEO option portfolios, we show that these proxies capture more than 99% of the variation in option portfolio value and sensitivities. Sensitivity analysis indicates that the degree of bias in these proxies varies with option portfolio characteristics, and is most severe in samples of CEOs with a large proportion of out-of-the-money options. However, the proxies' explanatory power remains above 95% in all subsamples.

Abstract:
In this paper, we derive a measure of diluted EPS that incorporates the economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the options' dilutive effect, and thus overstates reported EPS. Using firm-wide data on 731 employee stock option plans, our proposed measure suggests that economic dilution from options is, on average, 100 percent greater than dilution in reported diluted EPS using the FASB treasury-stock method.

We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per-share earnings as an input (e.g., Ohlson 1995) yield upwardly-biased estimates of the market value of common stock. We predict that when the difference between our measure of economic dilution from options and the FASB treasury-stock method dilution from options is greater, the observed return-earnings and price-earnings coefficients will be smaller, and we provide some (albeit weak) empirical support for this prediction.

Employee stock options, Dilution, Diluted earnings per share, Earnings response coefficients, Equity valuation

Abstract:
We derive a measure of diluted EPS that incorporates economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the dilutive effect of stock options, and thereby overstates reported EPS. Using firm-wide data on 731 employee stock option plans, we find that economic dilution from options in our proposed measure of options-diluted EPS is, on average, 100% greater than dilution in reported diluted EPS using the FASB treasury-stock method.

We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per share earnings as an input (e.g., Ohlson, 1995), yield upwardly biased estimates of the market value of common stock. We predict that observed return-earnings and price-earnings coefficients are expected to be smaller the greater the difference between our measure of economic dilution from options and FASB treasury-stock method dilution from options, and provide weak empirical support for this prediction.

Abstract:
We evaluate the influence of measurement error in analysts' forecasts on the accuracy of implied cost of capital estimates from various implementations of the 'implied cost of capital' approach, and develop corrections for the measurement error. The implied cost of capital approach relies on analysts' short- and long-term earnings forecasts as proxies for the market's expectation of future earnings, and solves for the implied discount rate that equates the present value of the expected future payoffs to the current stock price. We document predictable error in the implied cost of capital estimates resulting from analysts' forecasts that are sluggish with respect to information in past stock returns. We propose two methods to mitigate the influence of sluggish forecasts on the implied cost of capital estimates. These methods substantially improve the ability of the implied cost of capital estimates to explain cross-sectional variation in future stock returns, which is consistent with the corrections being effective in mitigating the error in the estimates due to analysts' sluggishness.

Cost of Capital, Implied Cost of Capital, Analysts' Forecasts, Discount Rate

Abstract:
We investigate Gompers, Ishii, and Metrick's (2003) finding that firms with weak shareholder rights exhibit significant stock market underperformance. If the relation between poor governance and poor returns is causal, we expect that the market is negatively surprised by the poor operating performance of weak governance firms. We find that firms with weak shareholder rights exhibit significant operating underperformance. However, analysts' forecast errors and earnings announcement returns show no evidence that this underperformance surprises the market. Our results are robust to controls for takeover activity. Overall, our results do not support the hypothesis that weak governance causes poor stock returns.

Corporate governance, market efficiency, analysts

Abstract:
We investigate Gompers, Ishii, and Metrick's (2003) finding that firms with weak shareholder rights exhibit significant stock market underperformance. If the relation between poor governance and poor returns is causal, we expect that the market is negatively surprised by the poor operating performance of weak governance firms. We find that firms with weak shareholder rights exhibit significant operating underperformance. However, analysts' forecast errors and earnings announcement returns show no evidence that this underperformance surprises the market. Our results are robust to controls for takeover activity. Overall, our results do not support the hypothesis that weak governance causes poor stock returns.

This is a revised version of a paper previously titled 'Does Weak Governance Cause Weak Stock Returns? An Examination of Firm Operating Performance and Analysts' Expectations' that was originally posted on April 21, 2004.

Corporate Governance, Market Efficiency, Analysts

Abstract:
We examine whether managers' trading decisions (both at a firm and personal level) are correlated with trading strategies suggested by the operating accruals and the post-earnings announcement drift (SUE) anomalies. We discuss advantages and disadvantages of the use of managerial trading activity to infer managers' private valuation about their own securities. Our results provide corroborative evidence for the accruals anomaly, i.e., managers' repurchase and insider trading behavior varies consistently with the information underlying the operating accruals trading strategy. On the other hand, we do not find corroborative evidence for the SUE anomaly.

Accruals, SUE, share repurchases, insider trading

Abstract:
We examine whether managers' trading decisions (both at a firm and personal level) are correlated with trading strategies suggested by the operating accruals and the post-earnings announcement drift (SUE) anomalies. We discuss advantages and disadvantages of the use of managerial trading activity to infer managers' private valuation about their own securities. Our results provide corroborative evidence for the accruals anomaly, i.e., managers' repurchase and insider trading behavior varies consistently with the information underlying the operating accruals trading strategy. On the other hand, we do not find corroborative evidence for the SUE anomaly.

Accruals, SUE, share repurchases, insider trading

Abstract:
In this paper, we review Pay Without Performance by Professors Lucian Bebchuk and Jesse Fried. The book develops and summarizes the leading critiques of current executive compensation practices in the U.S., and offers a negative, if mainstream, assessment of the state of U.S. executive compensation: U.S. executive compensation practices are failing, and systemic reform is needed. This review summarizes the book in some detail and offers some counter-arguments.

The book's thesis is that executive compensation practices are bad for shareholders (not "optimal") because they are the product of "managerial power." Managerial power arises because boards of directors at public companies are not independent of executives. Weak compensation committees thus do little to protect the firm in its pay negotiations with the CEO, leading to levels of executive pay that are both inappropriately high and have inappropriately low levels of incentives.

The authors offer a four part analysis of CEO pay. First, they describe and critique optimal contracting theory, which posits that executive compensation arrangements are designed to benefit shareholders. Second, they explain managerial power theory, in part through an in-depth analysis of current executive compensation practices. They assert the managerial power theory provides a superior explanation of current practices to the optimal contracting perspective. They also draw the strong implication that if managerial power exists, it means that something is wrong with the contracting process. Third, they claim that CEO compensation does not vary sufficiently with firm performance. They conclude with policy recommendations for changing compensation plans and improving corporate governance, for example by requiring that directors be more independent.

We agree that it is useful to consider the effect of managerial power on compensation, but we disagree with their interpretation of the consequences of this power. It is true that contract structures reflect CEO power, and that CEOs with more power get more pay, but this does not necessarily lead to the conclusion that CEO pay is not optimized for shareholders, nor does it imply that CEO pay needs reform. We show that in many settings where managerial power exists, observed contracts anticipate and try to minimize the costs of this power, and therefore may in fact be written optimally. As a result, the optimal contracting and managerial power perspectives are complementary, and not competing, explanations.

We next examine Bebchuk and Fried's claim that U.S. compensation is inefficient "pay without performance." Their analysis focuses on whether CEO annual pay varies with firm performance. While the book conducts an extensive analysis of the incentives provided by annual grants of stock options and equity it largely ignores the main source of CEO incentives: Large holdings of stock and options. These large equity holdings provide powerful performance incentives and ensure that the wealth of most CEOs varies strongly with their firm's stock price. The books' claim that CEO compensation is "pay without performance" does not appear correct once one considers this main source of CEO incentives. U.S. executives have very large pay-performance incentives, and their overall pay levels do not seem inappropriate.

We conclude by examining some of Bebchuk and Fried's policy recommendations. Bebchuk and Fried have missed some important aspects of executive pay and incentives. They have not shown that there are systematic failures with U.S. CEO compensation, and therefore have not shown that reform is needed.

CEO compensation, stock options, equity incentives, corporate governance

Abstract:
Piotroski [2000] investigates value stocks and examines whether a simple, accounting-based fundamental analysis strategy, when applied to historical data, can further enhance the returns to investing in high book-to-market firms. This discussion of Piotroski [2000] focuses on two main issues. The first issue is general, and questions whether the empirical literature on pricing anomalies can advance our understanding of pricing behavior in the absence of a plausible and rejectable alternative hypothesis to market efficiency. The second issue is more specific, and explores whether the author's analysis of the data provides convincing evidence that a simple accounting-based trading strategy, when applied to high book-to-market firms, generates substantial abnormal returns?

Capital markets; Market efficiency; Anomalies; Valuation; Fundamental analysis

Abstract:
Piotroski [2000] investigates value stocks and examines whether a simple, accounting-based fundamental analysis strategy, when applied to historical data, can further enhance the returns to investing in high book-to-market firms. This discussion of Piotroski [2000] focuses on two main issues. The first issue is general, and questions whether the empirical literature on pricing anomalies can advance our understanding of pricing behavior in the absence of a plausible and rejectable alternative hypothesis to market efficiency. The second issue is more specific, and explores whether the author's analysis of the data provides convincing evidence that a simple accounting-based trading strategy, when applied to high book-to-market firms, generates substantial abnormal returns?

Capital markets; Market efficiency; Anomalies; Valuation; Fundamental analysis

Abstract:
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.

Executive compensation, stock options, equity incentives, corporate governance

Abstract:
We examine whether publicly available performance measures other than stock price are economically significant in explaining changes in CEOs' firm-specific wealth. Similar to Antle and Smith [1986], we measure a CEO's firm-specific wealth changes as the sum of total annual pay and changes in the value of the CEO's portfolio of stock and option holdings. We examine the determinants of the variance of CEOs' wealth changes to infer the magnitude of their incentives. We decompose the variance of the wealth change into price-based and non-price-based components, and examine whether there is substantial variation in CEO wealth changes that is unexplained by price. Our results indicate that for most CEOs, stock return is the dominant component of their incentives. We find that for 65% of the CEOs in our sample, the variation in wealth changes that is explained by stock returns is at least 10 times greater than the variation that is unexplained by stock returns. This latter percentage is substantially larger when the CEOs are aggregated by industry to mitigate measurement error problems associated with computing by-CEO variances over a short time-series. Although there are some CEOs for which the non-price-based variation in annual total pay is significant, nearly all of this variation comes from non-cash pay, such as stock option and restricted stock grants. The variation in annual cash pay that is unexplained by price is greater than 1% of the total variation in CEO wealth changes for only 25% of the CEOs.

Abstract:
We examine the press' role in monitoring and influencing executive compensation practice using more than 11,000 press articles about CEO compensation from 1994 to 2002. Negative press coverage is more strongly related to excess annual pay than to raw annual pay, suggesting a sophisticated approach by the media in selecting CEOs to cover. However, negative coverage is also greater for CEOs with more option exercises, suggesting the press engages in some degree of "sensationalism." We find little evidence that firms respond to negative press coverage by decreasing excess CEO compensation or increasing CEO turnover.

press, media, executive compensation, corporate governance

Abstract:
We examine the press' role in monitoring and influencing executive compensation practice using more than 11,000 press articles about CEO compensation from 1994 to 2002. Negative press coverage is more strongly related to excess annual pay than to raw annual pay, suggesting a sophisticated approach by the media in selecting CEOs to cover. However, negative coverage is also greater for CEOs with more option exercises, suggesting the press engages in some degree of "sensationalism." We find little evidence that firms respond to negative press coverage by decreasing excess CEO compensation or increasing CEO turnover.

press, media, executive compensation, corporate governance

Abstract:
In a recent and influential empirical paper, Francis, LaFond, Olsson, and Schipper (2005) conclude that accruals quality (AQ) is a priced risk factor. We explain that FLOS' regressions examining a contemporaneous relation between excess returns and factor returns do not test the hypothesis that AQ is a priced risk factor. We conduct appropriate asset-pricing tests for determining whether a potential risk factor explains expected returns, and find no evidence that AQ is a priced risk factor.

Asset-pricing tests, Accruals quality, Information risk, Portfolio theory and diversification

Abstract:
In a recent and influential empirical paper, Francis, LaFond, Olsson, and Schipper (2005) conclude that accruals quality (AQ) is a priced risk factor. We explain that FLOS' regressions examining a contemporaneous relation between excess returns and factor returns do not test the hypothesis that AQ is a priced risk factor. We conduct appropriate asset-pricing tests for determining whether a potential risk factor explains expected returns, and find no evidence that AQ is a priced risk factor.

Asset pricing tests, Accruals quality, Information risk, Portfolio theory and diversification

Abstract:
We examine the determinants of options outstanding, grants, and exercises by non-executive employees. Using hand-collected data on options outstanding, grants, and exercises for a broad cross-section of 795 large firms for the years 1994 to 1997, we create measures of option values and incentives for both executive (top 5) employees and non-executive employees. We find that firms have committed large fractions of firm value to option plans, that a majority of these options are distributed to non-executives, and that substantial cross-sectional variation exists with respect to the fraction of the option plan that is distributed to non-executives.

We provide strong evidence that firms use options to a greater extent when they face capital requirements and financing constraints. This finding is consistent with cash constrained firms using stock option compensation in lieu of cash compensation. Our empirical results are also broadly consistent with the hypothesis that options held by non-executives vary as predicted by theory relating the distribution of equity incentives to firm characteristics. However, we find little evidence that firms manage the level of option plan incentives through the annual grant of options, suggesting that the corporate use of non-executive option plans is still evolving. In our cross-sectional regressions of annual exercises, we find strong evidence that the psychological reference point bias documented by Heath, Huddart, and Lang (1999) is valid in a broad sample of large corporations.

Abstract:
In contrast to a body of research starting with Demsetz and Lehn (1985) that predict and find a strong positive association between firm percent return variance and incentives, Aggarwal and Samwick (1999) predict and find a strong negative association between firm dollar return variance and incentives. A key assumption of Aggarwal and Samwick's analysis is that firm risk is the sole determinant of the pay-performance sensitivity, and that expected dollar return variance (the product of expected percent return variance and firm market value) is the correct proxy for risk. We demonstrate that dollar return variance is a noisy measure of firm market value and argue that A&S re-documents a size effect that is already well-known from prior literature. Because dollar return variance is shown to be a noisy proxy for firm size, the A&S empirical specification does not include an appropriate proxy for firm risk. The data consistently show that it is important to examine market value and percent return variance as separate determinants of the effects of size and risk on CEO incentives, as is done in the managerial ownership literature. In a model of CEO incentives that includes market value and risk as separate explanatory variables, we find that, contrary to the results in A&S, percent return variance is positively associated with incentives. The A&S empirical work cannot be interpreted as evidence of a negative relation between risk and incentives.

incentives, risk, uncertainty, standard agency model, managerial ownership

Abstract:
We examine the determinants of the stock and flow of CEO equity incentives. We define equity incentives as the total incentives provided by the CEO's holdings of stock and options, and we assume that firms have a target level of equity incentives for their CEOs. We model target incentive levels and use residuals from this model as a measure of the deviation between the CEO's existing level of incentives and the target level. Consistent with our hypothesis that firms use the flow of new incentives to correct deviations in the stock of incentives, we find that grants of new equity incentives to CEOs are negatively related to this residual. Grants of new equity incentives are positively associated with firm performance and average incentive grants are larger for firms with greater growth opportunities. Cash compensation is lower when firms make incentive grants to adjust CEOs? portfolio incentives back to the target level. This finding is consistent with our hypothesis that firms substitute cash compensation for equity compensation when equity compensation is used to adjust portfolio incentive levels. Overall, we find that firms effectively use grants of equity incentives to reward past performance and to re-optimize incentives for future performance.

Abstract:
We hypothesize that the payout method chosen to distribute a cash flow shock is primarily determined by the permanence of the shock. Dividend increases will be observed following cash flow shocks with a relatively large permanent component while repurchases will be used to distribute shocks that are primarily transient. Further, this implies that the market will use the announcement of the payout method to update its beliefs about the permanence of past and contemporary cash flow shocks. Using a large sample of dividend increases and repurchases, we find support for these hypotheses. The post-shock cash flows of dividend increasing firms do not fully revert back to pre-shock levels. Those of repurchasing firms completely revert to pre-shock levels, even settling below them. The stock price reactions to the announcements of both repurchases and dividend increases show strong evidence that the information in a payout announcement is not only the size of the payout, but also the method used to distribute the cash. The announcement of a payout method that does not match the market's expectations causes the market to update its previous assessment of the permanence of the cash flow shock.

Abstract:
We examine determinants of non-executive employee stock options outstanding, grants, and exercises for 756 firms during 1994 to 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 certain types of employees, provide retention incentives, and 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, Huddart, and Lang (1999).

Employee stock options, Compensation, Equity incentives

Abstract:
We examine determinants of non-executive employee stock options outstanding, grants, and exercises for 756 firms during 1994 to 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 certain types of employees, provide retention incentives, and 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, Huddart, and Lang (1999).

Employee stock options, Compensation, Equity incentives

Abstract:
Some practitioners and academics believe that firms can reduce earnings-per-share (EPS) dilution from employee stock option exercises by repurchasing shares. Academic studies in this area are motivated with some combination of the following assumptions about managerial behavior: 1) managers believe employee stock options "dilute" EPS; 2) managers believe share repurchases mechanically increase EPS; 3) managers and/or investors myopically focus on short-term EPS; 4) firms have severe cash constraints and high financing costs that force managers to fund EPS-motivated share repurchases with cash diverted from alternative investment opportunities. This discussion challenges the economic underpinnings of these arguments in the context of a recent paper by Bens, Nagar and Wong (2001) that investigates whether firms repurchase shares with cash diverted from profitable investment expenditures in an attempt to mitigate EPS dilution from employee stock option exercises. Specifically, this discussion suggests that there is reason to believe all of the four key assertions listed above are either incorrect or tenuous.

The intuition for why employee stock options are unlikely to dilute EPS is based on theory and empirical evidence that granting options to employees is conceptually similar to raising capital through issuing stock. Employees receive stock options as an equity stake in the corporation in return for services rendered. Like any other factor in production, corporations use these employee services to earn profits. As such, stock options are not expected to be any more dilutive than other forms of equity finance, such as common stock and most stock-based securities (e.g., convertible debt, warrants, convertible preferred stock) that contribute to the shares used to compute the denominator of EPS. In fact, because employee stock options are not expensed in earnings, one can argue that they dilute EPS to a lesser extent than other forms capital. Whether share repurchases mechanically increase EPS depends on whether the foregone return on cash used for repurchases is less than or greater than the ratio of the firm's earnings to the market value of equity (i.e., the earnings-to-price ratio). Given that earnings-to-price ratios have been in the 0.02-0.05 range for most firms in recent years, it is reasonable to expect that share repurchases actually decrease EPS for the majority of firms. Finally, the question of whether EPS-motivated share repurchases cause firms to divert cash from alternative investment opportunities requires the existence of severe cash constraints and high financing costs and/or the widespread absence of rational expectations on the part of management, conditions that are unlikely to be met for many firms that are accused of this practice.

Employee stock options; Share repurchases; Earnings per share; Payout policy; Investment; Capital expenditures; Corporate finance

Abstract:
Some practitioners and academics believe that firms can reduce earnings-per-share (EPS) dilution from employee stock option exercises by repurchasing shares. Academic studies in this area are motivated with some combination of the following assumptions about managerial behavior: 1) managers believe employee stock options "dilute" EPS; 2) managers believe share repurchases mechanically increase EPS; 3) managers and/or investors myopically focus on short-term EPS; 4) firms have severe cash constraints and high financing costs that force managers to fund EPS-motivated share repurchases with cash diverted from alternative investment opportunities. This discussion challenges the economic underpinnings of these arguments in the context of a recent paper by Bens, Nagar and Wong (2001) that investigates whether firms repurchase shares with cash diverted from profitable investment expenditures in an attempt to mitigate EPS dilution from employee stock option exercises. Specifically, this discussion suggests that there is reason to believe all of the four key assertions listed above are either incorrect or tenuous.

The intuition for why employee stock options are unlikely to dilute EPS is based on theory and empirical evidence that granting options to employees is conceptually similar to raising capital through issuing stock. Employees receive stock options as an equity stake in the corporation in return for services rendered. Like any other factor in production, corporations use these employee services to earn profits. As such, stock options are not expected to be any more dilutive than other forms of equity finance, such as common stock and most stock-based securities (e.g., convertible debt, warrants, convertible preferred stock) that contribute to the shares used to compute the denominator of EPS. In fact, because employee stock options are not expensed in earnings, one can argue that they dilute EPS to a lesser extent than other forms capital. Whether share repurchases mechanically increase EPS depends on whether the foregone return on cash used for repurchases is less than or greater than the ratio of the firm's earnings to the market value of equity (i.e., the earnings-to-price ratio). Given that earnings-to-price ratios have been in the 0.02-0.05 range for most firms in recent years, it is reasonable to expect that share repurchases actually decrease EPS for the majority of firms. Finally, the question of whether EPS-motivated share repurchases cause firms to divert cash from alternative investment opportunities requires the existence of severe cash constraints and high financing costs and/or the widespread absence of rational expectations on the part of management, conditions that are unlikely to be met for many firms that are accused of this practice.

Employee stock options; Share repurchases; Earnings per share; Payout policy; Investment; Capital expenditures; Corporate finance

Abstract:
We empirically examine standard agency predictions about how performance measures are optimally weighted to provide CEO incentives. Consistent with prior empirical research, we document that the relative weight on price and non-price performance measures in CEO cash pay is a decreasing function of the relative variances. Agency theory speaks to the weights in total compensation (annual total pay and changes in the CEO's equity portfolio value), however, and we document that very little of CEOs' total incentives come from cash pay. We also document that variation in the relative weight on price and non-price performance measures in CEO total compensation is an increasing function of the relative variances. The conflicting results using total compensation indicate that existing findings on cash pay cannot be interpreted as evidence supporting standard agency predictions. Based on our results, we suggest approaches for future research on performance measure use in CEO total compensation.

agency theory, cash pay, total compensation, equity incentives

Abstract:
We empirically examine standard agency predictions about how performance measures are optimally weighted to provide CEO incentives. Consistent with prior empirical research, we document that the relative weight on price and non-price performance measures in CEO cash pay is a decreasing function of the relative variances. Agency theory speaks to the weights in total compensation (annual total pay and changes in the CEO's equity portfolio value), however, and we document that very little of CEOs' total incentives comes from cash pay. We also document that variation in the relative weight on price and non-price performance measures in CEO total compensation is an increasing function of the relative variances. The conflicting results using total compensation indicate that existing findings on cash pay cannot be interpreted as evidence supporting standard agency predictions. Based on our results, we suggest approaches for future research on performance measure use in CEO total compensation.

agency theory, cash pay, total compensation, equity incentives

Abstract:
A growing body of literature suggests that because an executive is risk-averse and undiversified, he values equity compensation and incentives at less than market value. This discount on valuation is driven by the assumption that the executive is constrained from rebalancing his portfolio following an equity grant, and as such, the payment of equity compensation permanently increases the risk and incentives borne by the executive. We relax this exogenous assumption, and assume that firms contract with their executives and agree upon a specified level of risk. Firms expect and require that executives rebalance their portfolios when equity risk rises above or falls below the contracted level. Under these assumptions, we show that the executive does not discount the value of equity compensation or changes in the value of his equity portfolio.

The notion that firms write contracts that require executives to hold equity also suggests that executive contracts are more consistent with relative performance evaluation than has been found in prior empirical research. Specifically, this type of contract requires executives to reduce the fraction of their total wealth held in a well-diversified portfolio and to increase their investment in firm equity.

Stock options, Option valuation, Contracting, Equity incentives, Managerial compensation, Managerial ownership

Abstract:
We compute and compare risk-adjusted pay for US and UK CEOs, where the adjustment is based on estimated risk premiums stemming from the equity incentives borne by CEOs. Controlling for firm and industry characteristics, we find that US CEOs have higher pay, but also bear much higher stock and option incentives than UK CEOs. Using reasonable estimates of risk premiums, we find that risk-adjusted US CEO pay does not appear large compared to that of UK CEOs. We also examine differences in pay and equity incentives between a sample of non-UK European CEOs and a matched sample of US CEOs, and find that risk-adjusting pay may explain about half of the apparent higher pay for US CEOs.

CEO compensation, equity incentives, corporate governance, international comparisons

Abstract:
We offer an economic framework for generating predictions about the demand for conservative accounting reports. We define conservatism as: More timely recognition of losses than gains as a result of the costs and benefits of reporting verifiable information by managers and/or firms being asymmetric. We also discuss Bushman and Piotroski's interpretation of the speeds of "good news recognition" and "incremental bad news recognition" in "Basu-type" regressions as separate signals about accounting conservatism. Finally, we suggest avenues for future research that seeks to investigate the links between institutions and contracts, and between contracts and conservatism.

Financial reporting, conservatism, timeliness of loss and gain recognition, international accounting, political and legal institutions, contracting, compensation and incentives, debt contracts

Abstract:
A growing body of literature suggests that because risk-averse executives are undiversified, they value equity compensation at significantly less (over 30%) than market value. This valuation discount is driven by the assumptions that the firm ignores existing incentives when it grants equity, and does not allow executives to buy or sell firm stock for a multi-year period following a grant. We instead assume that firms contract efficiently, which means that contracts require executives to hold precise amounts of incentives (e.g., Holmstrom, 1979). Under this efficient contracting assumption, we show that executive discounts to the value of equity compensation are small (less than 6%). Finally, when firms write efficient contracts over executive wealth, these contracts are consistent with relative performance evaluation: they require executives to increase their exposure to firm-specific risk by reducing (increasing) the amount of wealth they hold in diversified portfolios (firm equity).

stock options, option valuation, contracting, equity incentives, managerial compensation, managerial ownership

Abstract:
This paper offers an explanation for a conservative reporting system, which we interpret as a requirement that firms disclose low realizations of economic events. Our explanation lies in the discount that the market applies to firm value in the presence of uncertainty. Specifically, if the market discounts firm value in the presence of uncertainty, we show that disclosing low realizations results in firm prices being higher on average than had the manager been allowed to act strategically. Thus, a manager will endorse a financial reporting system that requires her to report timely information about low realizations.

financial reporting, conservatism, timeliness of loss and gain recognition, contracting, corporate governance, debt contracts

Abstract:
Critics of U.S. executive pay practices have raised four major concerns: (1) executive pay is too high; (2) CEO contracts do not provide strong enough incentives to increase value (i.e., there is too little pay-for-performance); (3) options and other equity-based pay provide windfalls, large payoffs that reflect good luck more than good performance; and (4) CEOs have too much freedom to unwind their incentives. This negative, and increasingly mainstream, assessment of the state of U.S. executive compensation has led many observers to conclude that executive pay practices are fundamentally flawed and that systemic reform is needed. We shed light on these perceived problems with executive pay and, in so doing, provide some balance to what we find to be an increasingly one-sided debate. Our key points are that: (1) CEOs' stock and option holdings provide powerful incentives to increase value, and this is true regardless of whether or not annual pay varies with firm performance; (2) recent growth in annual pay may well be appropriate to compensate CEOs for recent growth in incentive risk borne through their stock and option holdings, and due to the increasing size and complexity of U.S. firms; (3) when viewed as a combination of market risk and firm-specific risk, conventional (that is, unindexed) stock and options may provide a simultaneous solution to shareholders' demand for executive rewards tied to company performance, and executives' preference to diversify their wealth; (4) U.S. CEOs show little evidence of widespread unwinding of incentives, and in cases where CEOs have too much incentives, it is appropriate to allow and encourage the CEO to exercise options and sell stock to rebalance her portfolio.

CEO, compensation, corporate governance, incentives

Abstract:
We examine three alternative explanations for excess endowments in not-for-profit firms: (1) growth opportunities, (2) monitoring, or (3) agency problems. Inconsistent with growth opportunities, we find that most excess endowments are persistent over time, and that firms with persistent excess endowments do not exhibit higher growth in program expenses or investments. Inconsistent with better monitoring, program expenditures toward the charitable good are lower for firms with excess endowments, and CEO pay and total officer and director pay are greater for firms with excess endowments. Overall, we find that excess endowments are associated with greater agency problems.

Corporate governance, Not-for-profit, Cash holdings, Endowment, Agency problems

Abstract:
We examine three alternative explanations for excess endowments in not-for-profit firms: (1) growth opportunities, (2) monitoring, or (3) agency problems. Inconsistent with growth opportunities, we find that most excess endowments are persistent over time, and that firms with persistent excess endowments do not exhibit higher growth in program expenses or investments. Inconsistent with better monitoring, program expenditures toward the charitable good are lower for firms with excess endowments, and CEO pay and total officer and director pay are greater for firms with excess endowments. Overall, we find that excess endowments are associated with greater agency problems.

Corporate governance, not-for-profit, non-profit, executive compensation, cash holdings, endowment, agency problems

Abstract:
This paper investigates whether the business press serves as an information intermediary. The press potentially shapes firms’ information environments by packaging and disseminating information, as well as by creating new information through journalism activities. We find that greater press coverage reduces information asymmetry (i.e., lower spreads and greater depth) around earnings announcements, with broad dissemination of information having a bigger impact than the quantity or quality of press-generated information. These results are robust to controlling for firm-initiated disclosures, market reactions to the announcement, and other information intermediaries. Our findings suggest that the press helps reduce information problems around earnings announcements.

Business Press, Information Asymmetry, Information Intermediaries, Earnings Announcements

Abstract:
We examine how corporations' exposures to interest rates, exchange rates, and commodity prices are related to investors' and analysts' expectations about firms' earnings. The results indicate that investors and analysts encounter difficulties estimating the earnings effects of the risk exposures that companies face. Stock returns around earnings announcements are associated with the magnitude of both recent quarter and lagged shocks to interest rates, exchange rates and commodity prices, especially for firms with large ex-ante exposures to these risks. Further, although intra-quarter revisions to analysts' forecasts do incorporate information about the earnings effects of the risk shocks, analysts' earnings forecasts do not fully resolve the uncertainty created by recent quarter and lagged shocks. Overall, the results suggest that analysts resolve between 28% and 56% of the total uncertainty created by interest rate, exchange rate, and commodity price shocks (the percentage reduction depends on the types and magnitudes of a given firm's exposures). The results are consistent with arguments that corporate financial risk exposures are not transparent to investors or analysts, and support recent research arguing that firms' hedging strategies consider this source of earnings uncertainty.

risk exposures, risk management, analysts' forecasts, interest rate risk, exchange rate risk, commodity price risk, risk disclosures

Abstract:
We re-examine the “underleverage puzzle,” which argues many corporations fail to take full advantage of debt tax shields. We show that prior results suggesting underleverage stem from biased estimates of tax benefits from interest deductions. We develop improved estimates of marginal tax rates using a non-parametric procedure that produces largely unbiased estimates of the distribution of future taxable income. We show that additional debt would provide firms with much smaller tax benefits than previously thought, and when distress costs, non-debt tax shields, and the benefits of financial flexibility are also considered, it appears plausible that most firms have tax-efficient capital structures.

capital structure, debt, marginal tax rates, corporate taxes

Abstract:
Ball and Shivakumar (2005) augment existing models of expected accruals to incorporate conditional conservatism. They document a robust asymmetry in the relation between accruals and economic losses and gains, and demonstrate that accruals models that incorporate this asymmetry have increased explanatory power.

This discussion of Ball and Shivakumar (2005) makes five main points: 1) incorporating asymmetry in gain and loss recognition is an important contribution to empirical models of expected accruals; 2) the economic underpinnings of asymmetry in loss and gain recognition remain open to considerable debate; 3) the extent to which accruals recognize gains in a timely manner remains an interesting but unanswered question; 4) non-working capital accruals are important to both the earnings process and accounting conservatism, yet modeling of non-working capital accruals has received little attention in the literature; and 5) incorporating asymmetry into the accruals process has important implications for estimating discretionary accruals and for future research in this area.

conservatism, expected accruals, discretionary accruals

Abstract:
Considerable research has documented the role of debt covenants and conservative financial accounting in addressing agency conflicts between lenders and borrowers. Beatty, Weber and Yu (BWY, 2008) document interesting, but mixed, findings on the relation between debt covenants and conservative accounting, and the extent to which the two contracting mechanisms act as substitutes or complements. In this paper, I discuss the economic roles of financial reporting, debt covenants, and conservatism within the debt contracting environment, and attempt to fit BWY's findings within this context.

financial reporting, accounting conservatism, contracting, corporate governance, debt contracts, debt covenants

Abstract:
Bowen, Ragjopal, and Venkatachalam (2008) explore whether managers, on average, use accounting discretion for reporting objectives that are in the interests of shareholders (e.g., signaling, tax minimization, etc.), or alternatively whether managers use discretion opportunistically in the presence of governance structures that allow greater discretion. The authors find that although accounting discretion is positively related to governance structures that allow managers greater discretion in decision-making, there is no evidence that the portion of accounting discretion related to governance structures is negatively associated with firm performance.

In this discussion, I emphasize the importance of decision rights allocation within widely held corporations, and how this allocation naturally leads to cross-sectional variation in the degree of discretion afforded managers. In contrast to much of the existing governance literature, I argue that governance structures that allow managers greater discretion in making decisions do not necessarily imply weak/poor governance. For example, it is difficult to see why a firm that allocates the least possible decision-making rights to their board or executives is necessarily the firm with highest quality governance. I also discuss why the observed relation between accounting discretion and firm performance may be uninformative about whether accounting discretion is used for opportunistic purposes. If shareholders/boards thoughtfully select an appropriate amount of overall decision-making discretion to allow managers, it will be difficult to determine whether specific types of discretion are used opportunistically.

Corporate Governance, Accounting Discretion, Earnings Management, Decision Rights Allocation

Abstract:
Accounting for employee stock options (ESOs) is controversial, with many arguing that it has substantial economic consequences. Such arguments rely on the assumption that one or more interested parties fixate on accounting numbers and fail to understand the real costs and benefits of ESOs. We review the various accounting issues and economic consequence arguments created by ESOs. We conclude that the accounting should facilitate a clear and consistent understanding of the costs of doing business, and that expensing ESOs best achieves this objective.

Accounting for Employee Stock Options, Stock Option Expense, Diluted Earnings Per Share

Abstract:
We hypothesize that firms choose dividend increases to distribute relatively permanent cash-flow shocks and repurchases to distribute more transient shocks. As predicted, we find that post-shock cash flows of dividend increasing firms exhibit less reversion to pre-shock levels compared with repurchasing firms. We also examine whether the stock market uses the announcement of the payout method to update its beliefs about the permanence of cash-flow shocks. Controlling for payout size and the market's expectation about the permanence of the cash-flow shock, the stock price reaction to dividend increases is more positive than the reaction to repurchases.

Payout policy; Stock repurchase; Buy-back; Payout choice; Dividend signaling

Abstract:
Following Dechow (1994) we investigate the relative usefulness (and economic significance) of short-versus long-term accruals in improving cash flows as a measure of performance. First, we re-examine Dechow's premise that long-term accruals are expected to be less useful than short-term accruals, arguing that the historical evidence is not sufficiently conclusive to inform our expectations. Second, alternative and more powerful tests are used to investigate the issue. Compared to short-term accruals, long-term accruals are found to add statistically significant, albeit smaller, increments in explanatory power to cash flows as a measure of performance. Third, extensions to Dechow (1994) provide the following insights. Our results are sensitive to the removal of potentially financially distressed firms and also those with relatively high growth options. The paper establishes the economic (as distinct from the statistical) significance of cash flows and both classes of accruals. The differential usefulness of accrual components is hypothesized, and found, to be a function of their relative materiality. Finally, utilizing only the depreciation component of long-term accruals worsens rather than improves cash flows as a measure of performance.

Abstract:
GAAP provides management with discretion over accounting accruals. Management might use the discretion to improve earnings as a measure of firm performance, or engage in opportunistic management of discretionary accruals. Empirical research on accrual management requires a model to identify discretionary accruals. We assess the effectiveness of alternative discretionary-accrual models using expected relations between stock returns and earnings components under the performance-measure and opportunistic-management-of-accruals hypotheses. None of the five models examined in the paper is effective in isolating discretionary accruals. We find that the discretionary-accrual models randomly decompose earnings into discretionary and nondiscretionary components.

Abstract:
The appropriateness of rules governing the financial reporting of derivatives securities depends critically on corporations' intended purpose for holding these instruments. Empirically, however, little is known about how these instruments impact firms' risk-exposures. This study examines the role of derivative securities in a sample of firms that begins using derivatives. The results are generally consistent with firms using derivatives for hedging purposes, and not for increasing shareholder risk. Firm risk (measured several ways) declines in the first year of derivative use. The realized risk reduction varies across firms as a function of the expected benefits from hedging and the characteristics of the derivatives position held. Finally, the decision to initiate a derivatives-based risk- management program is positively related to firms' expected benefits from hedging.

Abstract:
To control risk-related stockholder/manager agency conflicts effectively, equity holders are expected to manage, in addition to the pay-performance slope, the convexity of the relation between firm performance and managers' wealth. I examine the stock-based compensation of 278 corporate CEOs and find stock options play an economically significant role in increasing the convexity of the wealth-performance relation. The magnitude of the convexity provided by common stock is several orders of magnitude lower than that of stock options and of little economic importance for most CEOs in the sample. In cross-sectional tests, after controlling for the slope of the pay-performance relation, convexity is positively related to the proportion of growth options in firms' investment opportunity sets. This is consistent with firms providing managers with incentives to take risky projects when the potential loss from underinvestment in valuable risk projects is greatest. Convexity is also found to be negatively related to financial leverage and positively related to firm size. This result supports extant risk-management theory, and is consistent with firms providing managers with lower risk- taking incentives when the value created from hedging is likely to be greatest.