Does Conservative Stock Option Accounting Lead to Aggressive Cash Flow Reporting?

Abstract

In this paper, we examine whether recognizing higher option-based compensation expense leads to lower quality operating cash flows when options are exercised. FAS 123(R) changes the classification of the tax benefit from employee stock options in the statement of cash flows by splitting it into two parts: one reported in the operating section and the other in the financing section. Moreover, the proportion reported in the operating section increases with the amount of compensation expense previously recognized. We show that the tax benefit differs from other items of operating cash flows because it has no reliable association with future earnings. We also show that the predictive ability of current period earnings components declines when the tax benefit is classified as an operating cash flow. Finally, we find evidence that investors overprice the tax benefit, suggesting investors do not distinguish it from other operating cash flows. Taken together, our results suggest that the revised treatment of the tax benefit under FAS 123(R) gives rise to a curious situation where more conservative reporting at the grant date increases the proportion of future tax benefits that is included in the operating section, thereby lowering the quality of future reported cash flows.

Keywords: Stock options, conservatism, earnings quality

JEL Classification: M41