The Impact of Stock Options Compensation on Earnings and Probability of Bankruptcy

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INTRODUCTION

As the debate around excessive corporate executive compensation heats up in the United States in the era of Troubled Asset Relief Program (TARP) (1), the debate on the efficacy of stock options compensation is not yet settled. The restrictions on executive salaries and bonuses by firms that benefitted from TARP is likely to spread to comparable companies in the US. To avoid high political costs while at the same time keeping the option of providing incentives for managers to optimize firm value, Board of Directors may opt to increase equity related compensations such as stock options.

The objective of this study is to investigate the impact of stock options compensation on earnings and probability of bankruptcy of the firm. Hanlon, Rajgopal and Shevlin 2003 (HRS) document the incentive alignment hypothesis of executive stock options, but the authors use reported operating performance as the dependent measure. We argue that the positive contributions of executive stock options to reported earnings documented in that study could have been exaggerated if one considers the real potentials of earnings management, and so corporate boards and compensation committees should exercise caution in the interpretations of HRS finding. Therefore, in part, we examine executive stock options contributions to other measure of earnings after controlling for earnings management using nondiscretionary earnings as a dependent measure. While we find a positive contribution consistent with incentive alignment, the magnitude of such contribution is substantially lower. This suggests that nondiscretionary earnings will be a better measure of corporate performance as a guide for executive compensation decisions.

Prior studies have examined empirically and analytically a variety of issues ranging from the role of taxes in the decision to grant options (e.g., Klassen and Mawani, 2000), the choice between incentive stock options and nonqualified options (e.g., Austin et al, 1998), the tax deductibility of stock options (e.g., Balsam et al., 1996 & 1997; Mawani, 2003a), to the firm's disclosure behavior around the granting of the options (e.g., Aboody and Kasznik, 2000) as well as the tax and accounting income consideration for the cancellation of executive stock options (e.g., Mawani 2003b). However, very few (e.g., HRS; Kato et al, 2005; Sanders and Hambrick, 2007) have attempted to provide direct evidence of the impact of executive stock options on the firm's earnings. HRS conclude that every dollar of stock options (using Black-Scholes values) granted to the top five executives contributes $3.71 to future operating earnings of the company over the next five years. Kato et al. (2005), using Japanese data and an event study methodology, also conclude that operating performance improves with stock options. However Sanders and Hambrick (2007) have shown that while stock options do affect CEO behaviors, their heavy use produces more losses than gains. Other agency theorists wondered whether the traditional ESO plans for executives are not leading to creative ways of managing earnings while ignoring the cost of equity (Jensen, Murphy, and Wruck, 2004).

These mixed results are manifestations that the question of whether stock options induce mangers to take appropriate actions is still not settled. Researchers using the incentive alignment hypothesis argue that stock options compensation could be utilized to reduce the incentives asymmetry between managers and shareholders (e.g., Rajgopal and Shevlin, 2002; HRS; Mawani, 2003a). However, other researchers using the rent extraction hypothesis argue that this compensation package can be a conduit of transferring wealth from shareholders to management/top executives (e.g., Johnson 2003; Aboody and Kasznik, 2000; Baker, Collins, and Reitenga, 2003).

Our study is motivated by the need to fill this important gap in the literature with the intent to examining the impact of granting options to top corporate executives on the firms' earnings and the probability of bankruptcy, and by extension the value of the firm. …