The Determinants and Consequences of Changes in Executive Option-Based Compensation Around the Issuance of SFAS 123R

Abstract

We investigate the causes and consequences of changes in option-based compensation for the top five executives around the issuance of SFAS 123R, which requires firms to expense the fair value of their employee stock options (ESOs) on their income statements. We hypothesize that firms with greater tendencies to substitute ESOs for other forms of compensation to report higher earnings pre SFAS 123R cut back more on ESOs. Consistent with our hypotheses, we find that reduction in the proportion of total compensation paid in ESOs increased in the firm's propensity to take advantage of ESOs' favorable accounting as proxied by debt contracting concerns, tendency to achieve earnings benchmarks using ESOs' favorable accounting treatment, corporate governance weakness, and if the firm accelerated vesting of outstanding ESOs in response to SFAS 123R. We show that firms replaced ESOs with restricted stock post SFAS 123R, but the substitution was less than dollar for dollar. We also find that ESO cutbacks around the issuance of SFAS 123R reduced abnormal compensation without harming firms' operating performance.

Keywords: Employee stock options, SFAS 123R, Executive compensation

JEL Classification: G32, M41, M44, M52, J33