Academic journal article Accounting Horizons

Managing Pro Forma Stock Option Expense under SFAS No. 123

Academic journal article Accounting Horizons

Managing Pro Forma Stock Option Expense under SFAS No. 123

Article excerpt

SYNOPSIS: We investigate whether footnote disclosures under Statement of Financial Accounting Standards (SFAS) No. 123 are managed in 1996, the first year that the disclosure was required. The 1996 phase-in of SFAS No. 123 provided firms with a unique opportunity to manipulate the pro forma disclosure in the initial years. SFAS No. 123 allows firms discretion in estimating the value of their stock option grants and in allocating that value across accounting periods. Although we find little evidence that firms manage the estimated value of their option grants, we find that firm-specific incentives affect how that value is allocated. Specifically, firms that provide high levels of either CEO compensation or stock option compensation relative to performance allocate a smaller proportion of the options' value to the 1996 pro forma expense, apparently to reduce criticism of that compensation. Small firms and firms that recently went public also allocate a smaller proportion of option value to the 1996 pro forma ex pense, apparently to increase perceptions of their profitability.

We conjecture that firms were less likely to manage the value of the options granted than the allocation of that value in 1996 because the parameter estimates underlying the reported option value must be disclosed in the footnote, whereas the inputs to the allocation computation are not disclosed.

These results, which suggest that firms manipulated pro forma stock option expense when their estimate choices cannot be observed, have implications for both standard setters and financial statement users. In particular, the FASB's current deliberations on the transition from footnote disclosure to income statement recognition for stock options should consider additional disclosures to minimize unobservable choices. More generally, the FASB may reduce potential manipulation by requiring expanded disclosures about the choices used in computing both pro forma and reported numbers.

Keywords: SFAS 123; disclosure; earnings management; stock options; FASB statements.

Data Availability: Data used in this study are publicly available from the sources identified in the paper.

INTRODUCTION

In a review of recent studies on accounting choices that impact the firm's financial statements, Healy and Wahlen (1999) indicate that managers make accounting choices to:

* influence stock market perceptions,

* increase management compensation,

* reduce the likelihood of violating lending agreements, and

* avoid regulatory intervention.

Recent studies also find that proxy statement disclosures are managed to influence perceptions about performance and compensation (e.g., Murphy 1996; Bannister and Newman 2002).

This study extends this literature by examining whether information in mandated financial statement footnotes is managed, using the information disclosed under FASB Statement No. 123, Accounting for Stock-Based Compensation. Although SFAS No. 123 encourages firms to expense the estimated fair value of employee stock options granted, virtually no firms did so prior to 2002. Instead, firms chose to report the pro forma impact of stock option grants on net income in a footnote, along with the fair value of those grants and the major assumptions underlying their valuation.

Users of financial information may place less weight on footnote disclosures than on the information recognized in financial statements. For example, net income reported in the financial statements receives more publicity than pro forma income in the SFAS No. 123 footnote and is generally used in calculating price-earnings and other financial ratios. Firms therefore have less incentive to manage footnote disclosures.

Still, Watts and Zimmerman (1978) argue that firms have incentives to manage supplemental disclosures. Amir and Ziv (1997) suggest that manipulating supplemental disclosures is less difficult due to lower auditor scrutiny. …

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