Expensing Executive Stock Options: The Agency Problem and Structure of Management Compensation

Abstract

This research examines the valuation effect and the factors associated with firms' decisions to expense executive stock options, as well as determinants of market reaction to expensing announcements. The likelihood of expensing is found to be higher for firms subject to fewer agency problems and having a "share-holder friendly" corporate governance structure. These results suggest that the decision to expense is heavily influenced by the extent of discipline, monitoring, and how closely the interests of management and stockholders are aligned.

The mean and median announcement-period returns are not found to be significantly different from zero. However, the post-announcement period abnormal returns are negative and statistically significant. The cross-sectional analysis provides support for the prediction that the market reaction to expensing has a differential valuation effect related to the level and structure of management compensation. Namely, companies with a higher percentage of long-term compensation (to total compensation) and a higher percentage of total compensation (to total assets) have negative, or less positive, average abnormal returns.

These results are consistent with the first part of the argument advanced by the proponents of expensing options, that recognition causes reported earnings to decline and share prices to follow. The second part of their argument is that boards of directors will then be less inclined to grant excessive options is not supported. The perceived benefits (if capitalized in share price at announcement time) of the boards' action in terms of more transparency, is either absent or does not offset the negative impact of lower earnings and share prices of expensing firms.

Keywords: Stock Options, Expensing, Compensation, Recognition

JEL Classification: G12, G34, M41, M44, J33