Tuesday, September 12, 2006
Stock Option Expensing and Market Signals
In a recent post, Larry Ribstein referenced a N.Y. Times article about the lack of share price effect from the backdating scandals. However, a recent paper in Financial Management found that firms that expensed their options had better transparency and alignment with shareholder interests. At the same time, they found that the expensing announcement had little to no effect on share prices. The expensing issue is related to the backdating scandal, as firms and executives who backdated their options did so in order to take advantage of the non-expensing accounting rules in place at the time. If expensing shows greater transparency and alignment with shareholders, then backdating might show the opposite.
The paper is Executive Stock Options: To Expense or Not?, by Sanjay Deshmukh, Keith Howe, and Carl Luft. Unfortunately, it's not available for free, but you can find it at pp. 87-106 of the spring issue of Financial Management. Here's the abstract:
In analyzing the decision to expense stock options, we find a greater likelihood of options expensing for firms with greater transparency and a closer alignment of interests between managers and shareholders. These results provide indirect evidence that expensing is more likely in firms that practice good corporate governance. We show that firms are less likely to expense when option usage is higher and that this negative relation is stronger for firms that are smaller, have high growth, and are less profitable. We also find that the announcement period returns are not significantly different from zero.
Their study compared results from 207 firms which announced voluntary expensing between 2002 and 2003 with a sample of 1,323 firms that did not expense. In their analysis, the authors found that expensing firms have a higher number of analysts' reports, higher share ownership by executives, more leverage, and higher dividend yields. From this, the authors argue that expensing firms are more transparent and are more likely to have closer alignment between executives and shareholders. This provides indirect evidence of better corporate governance.(The authors did not find any significant result on an explicit governance variable using the governance index developed by Gompers, Ishii and Metrick in Corporate Governance and Equity Prices, 118 Q.J. Econ 107 (2003), but they argue that the index does not reflect "the strength [of the governance provisions] in terms of their impact on managerial choice.").
I have been most concerned about backdating which involved managers tricking the board into providing higher compensation that the board realized. (See, e.g., Comverse.) But even the "best" backdating required lying as to the date of the option in order to circumvent the accounting rules. This paper is further evidence of the implications for stock option accounting on corporate practices.
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Matt: I don’t follow your post. Larry’s main point in the linked post concerning backdating “is that the market had looked through the accounting and wasn't fooled.” Your description of the paper seems to support that point. As you note, the paper “found that the expensing announcement had little to no effect on share prices,” i.e., the market looked through the accounting and wasn’t fooled.
Posted by: Bill Sjostrom | Sep 12, 2006 1:17:08 PM
My point is that Larry's point does not refute Vic's point. The expensing announcement had no effect on stock prices, but this study still found that expensing firms were more likely to have transparency and a closer alignment of interests between shareholders and managers.
Posted by: Matt Bodie | Sep 12, 2006 2:25:57 PM
Interesting paper, but I'm not sure I follow where you are going here either. I interpret the no share price effect (as reported, I have not read the paper) to support Ribstein's (and Manne & Wright's, and Sjostrom's) claims re: backdating not fooling the market. Are you suggesting this is the wrong interpretation? You reference additional transparency and "closer alignment," but I don't know what to make of this in the context of no share price changes upon announcement.
Further, Vic's point is not referenced in the post but you mention this in your comment to Sjostrom suggesting that Vic is saying something about the harm of backdating even if the market is not fooled. But Vic writes: "Most accounting experts believe, contrary to what Ribstein and TOTM suggest, that accounting does matter, at least to some firms." Perhaps this means accounting matters to some firms, but not to the market --- but this proposition would not contradict that raised by Ribstein, Manne, myself, and Sjostrom. So, I take Vic to be saying that perhaps we (TOTM, Ribstein) are all overly sanguine, as an empirical matter, about our belief that accounting measures will not fool the market in the backdating context (I believe you cleverly labeled this as "accounting nihilism"). If I'm wrong about what Vic was getting at, I hope he will correct me. But the important thing here is not whether or not the evidence in the paper challenges Vic's assertion about the state of the evidence, it is the evidence that the market was not fooled.
But I'm not sure I understand what you are suggesting we're to make of "a closer alignment of interests between shareholders and managers" in the context of a finding of no effect on stock prices? And further, I am interested to know what you mean by "This paper is further evidence of the implications for stock option accounting on corporate practices." What are those implications in the context of such a finding?
Posted by: Josh Wright | Sep 12, 2006 3:02:17 PM
I'm not sure where the confusion is. The authors found that firms that decided to expense their options had higher share ownership by executives, more leverage, and higher dividend yields. They labeled these characteristics as "a closer alignment of interests between managers and shareholders." (I believe Larry has argued for higher, forced dividends as a way of promoting shareholder interests.) Now, when the firms announced their decision to expense options, their share prices (according to this study) did not change. But that does not mean the decision to expense was meaningless. It may simply mean that the decision to expense is a reflection (or an example) of the firm's overall commitment to shareholders. That commitment may already be incorporated into the share price.
Backdating is different, since it was not permissible under accounting guidelines. But it reflects a commitment to non-expensing -- in fact, it used the non-expensing guidelines to slip in higher compensation. So, arguably, backdating may be reflective of a weaker commitment to shareholders. Or perhaps it shows a stronger commitment to short-term shareholder value, since the purpose of non-expensing is (presumably) to keep earnings higher than they would be if options were expensed. Many of the illegalities of the 1990s were efforts to further short-term shareholder primacy, which also happened to coincide with executive stock option vesting periods.
The bottom line is: if options expensing is reflective of a commitment to shareholder primacy, then backdating may be reflective of a culture of managerial primacy. Such a culture may already be incorporated into the share price by the time that options are expensed or backdating is revealed. Given the historical nature of the backdating scandals, it is even more likely that the market has in some way accounted for the problem. But one final proviso: we should look for more evidence than anecdotes from a N.Y. Times article before determining that backdating actually had no effect on the market price for shares.
Posted by: Matt Bodie | Sep 12, 2006 3:53:07 PM
Well, at least we agree with that we should look for more evidence than the NY Times article for determining the impact of backdating on share prices to test whether the correlation found here explains which firms engaged in backdating.
Posted by: Josh Wright | Sep 12, 2006 4:54:48 PM