Voluntary Disclosures That Disavow Mandatory Disclosures The Case of Stock Options

Voluntary Disclosures That Disavow Mandatory Disclosures: The Case of Stock Options Walter G Blacconiere Kelley School of Business Indiana University James R Frederickson Hong Kong University of Science and Technology Marilyn F Johnson Eli Broad College of Business Michigan State University Melissa F Lewis Kelley School of Business Indiana University Draft 0.999: April 14, 2004 Preliminary Comments welcome Please not quote without permission The authors thank David Aboody, Frank Acito, Dave Farber, Tom Linsmeier, Luann Lynch, Srini Rangan, Steve Rock, Jerry Salamon, Paul Simko, and participants at accounting workshops at UCLA, University of Connecticut, University of Colorado, Michigan State University, and University of Virginia for comments We also thank Hyung Soon (Ross) Park and Christine Reinoehl for research assistance Walt Blacconiere gratefully acknowledges the financial support of Ernst & Young, L.L.P and the Kelley School of Business at Indiana University Voluntary Disclosures That Disavow Mandatory Disclosures: The Case of Stock Options Abstract Accounting for employee stock options has been a controversial issue Current U.S regulations require firms to either recognize employee stock options as an expense on the income statement or disclose pro forma income figures in the footnotes adjusted for this expense Among firms that use footnote disclosure, some firms include language that disavows the calculation of stock option compensation This study investigates the decision to disavow stock option compensation expense disclosed in the footnotes We consider two non-mutually exclusive hypotheses First, we predict that some firms disavow due to concerns about the reliability of the stock option compensation amount Second, we predict that some disavowals are motivated by executive compensation costs Based on a sample of over 1,300 firms during 2001, we find that over 18% disavow pro forma income adjusted for stock option compensation Our evidence provides only weak support for the prediction that disavowals are related to reliability concerns However, there is stronger support for our predictions regarding compensation concerns We find that sample firms are more likely to assert that pro forma income is unreliable in cases where the CEO’s stock option compensation is high relative to total to the CEO’s total compensation and in cases where the CEO’s total compensation is “excessive” These latter results suggest that executive compensation costs influence disavowal decisions Voluntary disclosures that disavow mandatory disclosures: The case of stock options Introduction The Financial Accounting Standards Board (FASB) issued SFAS 123, “Accounting for Stock Options,” in 1995 This accounting standard requires that firms calculate the expense for stock options granted to employees based on the fair value of the options on the grant date However, SFAS 123 gives firms a choice between income statement recognition versus footnote disclosure Specifically, a firm either can recognize stock option compensation expense as a determinant of reported net income in the income statement (i.e., income statement recognition) or the firm can forego income statement recognition and instead disclose pro forma income figures in the footnotes that assume stock option compensation was expensed (i.e., footnote disclosure) Although the exposure draft of SFAS 123 required income statement recognition and the FASB encourages income statement recognition, the vast majority of U.S firms historically elected footnote disclosure.1 Among firms that use footnote disclosure, some firms include language that disavows the calculation of the stock option compensation expense amount For example, Intel includes the following disavowal statement in the stock option footnote from their fiscal 2001 annual report: The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility Because the company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models not necessarily provide a reliable single measure of the fair value of employee stock options According to The Wall Street Journal Online (April 22, 2003), only five publicly-held firms (Boeing Co., Hawaiian Electric Industries, Winn-Dixie Stores Inc., Level Communications Inc., and MacDermid Inc) treated stock option compensation as an expense in prior periods However, many additional firms started reporting stock option compensation expense in net income more recently For example, Weil and Cummin [2004] state that “nearly 500 U.S.-listed companies have begun expensing stock option pay or intend to start” (p C1) See Aboody, Barth, and Kasznik (2004) for an examination of the factors associated with firms’ decisions to voluntarily recognize stock-based compensation expense under SFAS 123 Voluntary disclosures that disavow mandatory disclosures: The case of stock options The research question addressed in the paper is: why firms disavow the mandated accounting disclosure concerning stock option compensation expense? More specifically, this study investigates the decision to disavow stock option compensation expense disclosed in the footnotes We posit that this decision is made because the firm (or the firm’s manager) perceives that the benefits of disavowing outweigh the costs.2 We investigate two hypotheses regarding the decision to disavow First, we predict that some disavowals are motivated by concerns about the reliability of the stock option compensation amount In effect, these firms are conveying concerns regarding the validity of the option pricing model and/or assumptions used to compute the compensation amount Second, we expect that some disavowals are motivated by compensation-related incentives If executive compensation appears to be excessive and/or the CEO receives a substantial portion of total compensation from stock option grants, we expect that the firm is more likely to disavow stock option compensation reported in the footnotes Three characteristics of this particular setting motivate our investigation First, the effect of stock option compensation expense on earnings appears to be significant Botosan and Plumlee [2001] find that pro forma fully diluted earnings per share adjusted for stock option compensation is at least 22% lower than the amount based on reported net income for a sample 100 of “America’s fastest-growing” firms (as identified by Fortune magazine).3 More recently, Taub [2004] notes that earnings per share for the S&P 500 would be reduced by an estimated 7.4% if stock option compensation expense is included in reported net income Second, stock option accounting has been and continues to be an important and For example, benefits could include the perception that the firm is enhancing the quality of the financial statement disclosures by providing additional useful information to stakeholders (e.g., alerting shareholders about legitimate reliability concerns in estimating stock option compensation expense) However, firms might be hesitant to include statements that explicitly contradict information in their audited financial statements that is required under GAAP Such disavowals could be interpreted as the firm having lower quality financial reporting As an extreme example, Yahoo! Inc reported net income of over $70 million for fiscal 2000 while disclosing stock option compensation adjusted pro forma loss in the footnotes of over $1.2 billion 2 Voluntary disclosures that disavow mandatory disclosures: The case of stock options controversial issue The FASB proposed income statement recognition for stock option compensation in 1993, but relaxed its position and ultimately allowed either income statement recognition or footnote disclosure in the face of significant lobbying and the threat of Congressional action.4 On March 31, 2004, the FASB issued an Exposure Draft (titled “ShareBased Payment”) that calls for income statement recognition of estimated stock option compensation expense Again, the FASB’s current proposals have generated significant controversy.5 Third, the voluntary disavowal of a mandated accounting disclosure included in audited financial statements is relatively rare in practice Although almost all firms provide general caveats regarding estimates that are included in financial statements, a specific statement questioning the usefulness of accounting information is much less common The disavowal statements examined in our study relate to a specific measure of income that must be reported in an audited footnote under GAAP Thus, we believe that an investigation of the decision to disavow stock option compensation expense disclosed in the footnotes is warranted We perform analysis on a sample of over 1,300 firms from the Execucomp database Of these firms, 248 (18.5%), representing a wide cross-section of publicly-traded firms, include a For example, Botosan and Plumlee [2001] note that there were over 1,700 comment letters related to the exposure draft of SFAS 123 Revsine et al [2002] note that a Senate bill was introduced that would have eliminated the FASB’s independence by requiring the Securities and Exchange Commission to approve all new FASB standards For example, Senators Enzi and Reid have proposed a bill that would require expensing stock option compensation on a limited basis but would allow an exemption for small businesses and start-ups firms in a response to the FASB proposal In a statement following a Senate hearing last week on the FASB proposal, Enzi said that the FASB “is ill equipped to conduct economic impact studies of the accounting standards it adopts … It was evident that FASB is not listening to small businesses and not taking their concerns seriously.” (Wells [2003]) For example, Wal-Mart’s fiscal 2001 annual report includes the following wording in their footnote: “The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions These estimates and assumptions affect the reported amounts of assets and liabilities They also affect the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period Actual results may differ from these estimates.” Voluntary disclosures that disavow mandatory disclosures: The case of stock options disavowal of stock option compensation (or the resulting pro forma income) in the footnotes of their fiscal 2001 financial statements Our evidence provides weak support for the prediction that disavowals are related to reliability concerns in measuring stock option compensation Although the standard deviation of stock price volatility is related positively to the decision to disavow, this relation is only significant in univariate tests However, our results suggest that concerns regarding executive compensation influence the decision to disavow We find a significant relation between disavowals and both the ratio of the CEO’s stock option compensation to total compensation and a measure of “excessive” CEO total compensation As expected, we find that firms disavow in cases where the stock option compensation expense materially affects return on assets Finally, our results suggest that smaller firms are more likely to disavow This study contributes to accounting research in at least two areas First, this study contributes to prior and ongoing research related to stock option accounting (examples include Matsunaga [1995], Aboody [1996], among many others) by investigating disavowals of stock option accounting disclosures This study most directly extends research that examine firms’ lobbying behavior prior to the issuance of SFAS 123 (Dechow, Hutton, and Sloan [1996] and Hill, Shelton, and Stevens [2002]), as well as studies that investigate the question of whether firms manage stock option compensation expense under SFAS 123 (Balsam, Mozes, and Newman [2003] and Aboody, Barth, and Kasznik [2003]) Second, because disavowals are voluntary, we also potentially contribute to the extensive literature concerning voluntary disclosure (see Healy and Palepu [2001] and Core [2001] for recent reviews of this research) In particular, this study is related to recent research that has focused on voluntary pro forma earnings disclosures (examples include Lougee and Marquardt Voluntary disclosures that disavow mandatory disclosures: The case of stock options [2004], Frederickson and Miller [2004], among others) In these cases, the firm voluntarily provides two sets of financial information, one based on GAAP and one based on the firm's or industry's own definition The presence of the latter is an implicit disavowal of the mandated GAAP information In contrast, our study considers an explicit disavowal of a mandatory footnote disclosure To the best of our knowledge, this is the first study to examine the determinants of a voluntary disclosure that explicitly disavows a mandated disclosure.7 Since disavowals seemingly circumvent the intent of mandated disclosures, it is important to understand whether disavowals are motivated by concerns about the disclosed information or for other reasons (e.g., opportunism) The remainder of the paper is organized as follows Section two discusses accounting for stock option compensation and develops the hypotheses investigated in the paper Section three presents the research design including discussion of the sample, model, and variables Section four presents results of our empirical analysis, and section five concludes Background and Hypothesis Development 2.1 Accounting for Stock Option Compensation Currently, the accounting for stock options is governed by Accounting Principles Board Opinion (APB) No 25 and Statement of Financial Accounting Standards (SFAS) No 123 APB 25 (issued in October 1972) defines stock option expense as the measurement date difference between the stock price and option exercise price, multiplied by the number of options Since the measurement date is defined as the date at which the exercise price and number of options are known, the measurement date of fixed option grants is the grant date Most employee stock Frederickson, Hodge, and Pratt [2004] have a concurrent study that uses an experiment to investigate the effect of disavowals on investor judgment Voluntary disclosures that disavow mandatory disclosures: The case of stock options option grants have a fixed exercise price that equals the stock price at the grant date, implying that the associated expense is zero under APB 25 The FASB reconsidered the accounting for stock-based compensation and issued the exposure draft of SFAS 123 in 1993 The exposure draft proposed that stock option expense be based on option fair values at the grant date, estimated using an option-pricing model The FASB proposal was consistent with Black and Scholes [1973] who demonstrated that the value of an option is not solely defined by the difference between the stock price and the exercise price.8 However, in response to political pressure, the FASB subsequently modified its proposal to allow firms to substitute the measurement provisions in SFAS 123 with those in APB 25 SFAS 123 (issued in October 1995) defines stock option expense as the option’s fair value at the measurement date Fair value is to be calculated using an option pricing model whose inputs include the option’s exercise price, the current stock price, the expected life of the option, expected dividend yield, expected risk-free interest rate, and, for publicly traded firms, the expected stock price volatility.9 Once a fair value per option has been calculated, it is multiplied by the number of options expected to vest and the resulting amount is amortized over the vesting period.10 If a firm elects, instead, to use APB 25 to measure stock option expense, it must provide footnote disclosure of a variety of items, including pro forma net income Virtually all firms SFAS 123 does not dictate a specific option pricing model However, based on a search of the EDGAR database, Hodder, Maydew, McAnally, and Weaver [2004] find that only eight firms did not use the Black-Scholes model to estimate stock compensation expense for 2002 Use of the expected life of the option, as opposed to its stated term to maturity, reflects the fact that employees systematically exercise options early because employee stock options are nontransferable (Huddart and Lang [1996]) 10 Use of the number of options expected to vest, rather than the number granted, reflects the fact that not all granted options vest because some employees terminate employment before the end of the vesting period Voluntary disclosures that disavow mandatory disclosures: The case of stock options initially applied the measurement provisions of APB 25, hence disclose pro forma net income Other disclosures required under SFAS 123 include inputs to the option fair value calculation (i.e., option exercise price, expected option life, dividend yield, risk-free interest rate, and stock price volatility), estimated fair value of options granted, vesting period, and number of options granted, forfeited, and exercised 2.2 Saliency and the Form of Executive Stock Option Disclosures SFAS 123 generated significant political controversy The FASB position suggests that stock options are an expense that can be reliably measured and, therefore, should be recognized in determining net income Its position is based on the argument that issuing stock options transfers claims on the firm’s equity from existing shareholders to employees Because the employees provide services to the firm, the value of the transferred ownership claims represents a cost of generating revenue In contrast, opponents argue that no expense should be recognized on the income statement because the amount of the expense cannot be reliably measured Option pricing models are based on assumptions – such as constant volatility – that are often not descriptively valid Opponents also question the applicability of option price models to the valuation of nontransferable, forfeitable employee stock options held by risk averse, undiversified executives More recently, significant stock price declines in high technology industries and a rise in the number of accounting restatements and related scandals have reopened the debate about the appropriate accounting treatment of stock options Partly in response to pressure from shareholder activists, several bills have been introduced into Congress For example, Senators Levin and McCain had sponsored a bill that would disallow the tax deductibility of employee Voluntary disclosures that disavow mandatory disclosures: The case of stock options stock options unless the options were also treated as an expense for financial reporting purposes Related, the International Accounting Standards Board issued International Financial Reporting Standard (IFRS) 2, a global standard that would require the income statement recognition of stock option compensation expense under the fair value method Likewise, the FASB has issued an Exposure Draft that would require expensing of stock option compensation starting in 2005 Much of the debate about stock option accounting has implicitly focused on the argument that shareholders will not pay sufficient attention to unrecognized stock option compensation that is disclosed in the footnotes to the financial statements (e.g., see Greenspan [1999], Ohl [2000] and Orr [2001], each of whom espouses this view.) Related, companies devote resources to lobbying about disclosure versus recognition even though the terms of stock option grants can be inferred from information in footnotes and proxy statements This behavior reflects a belief that investors fail to fully use information that is presented less saliently Research in psychology supports this belief Psychologists have repeatedly examined how people form predictions in settings where the variable of interest is a stochastic function of multiple cues (e.g., Kruschke and Johansen [1999]) A consistent finding is that cue saliency affects judgments and decisions For example, individuals place greater weight on particular cues when those cues are made salient than when they are not Psychology research also has documented that due to limited information processing abilities, the way in which information is presented affects judgments and decisions (Payne, Bettman and Johnson [1993]).11 Consistent with the psychology literature, experimental studies in accounting have documented that the form in which information is presented influences investors’ trading and/or valuation judgments Libby, Bloomfield, and Nelson [2001] and Maines [1995] provide detailed surveys of the experimental literature on financial information processing 11 Voluntary disclosures that disavow mandatory disclosures: The case of stock options regression models suggests, at best, only weak support for this hypothesis The accounting for stock option compensation expense has been controversial There have been significant lobbying efforts by interested stakeholders regarding this issue over (at least) the last decade The stock option disavowal decision examined in this study can be viewed as a form of “lobbying” and/or an attempt to “manage perceptions” Thus, we are able to investigate the role of disclosure incentives in a unique and important setting Our findings suggest that disavow decisions in this setting are, on average, more likely to be influenced by CEO compensation concerns as opposed to legitimate concerns about the reliability of information reported in financial statements Thus, regulators and other stakeholders should be aware of the influence of managerial incentives on the decision to voluntarily disavow mandatory accounting disclosures 24 Voluntary disclosures that disavow mandatory disclosures: The case of stock options References Abarbanell, J and B Bushee 1997 Fundamental analysis, future earnings, and stock prices Journal of Accounting Research 35: 1-24 Aboody, D 1996a Recognition versus disclosure in the oil and gas industry Journal of Accounting Research 34: 21-32 Aboody, D 1996b Market valuation of employee stock options Journal of Accounting and Economics 22: 357 - 391 Aboody, D, M Barth, and R Kasznik 2001 SFAS 123 stock-based compensation expense and equity market values Working Paper, UCLA and Stanford University Aboody, D., M Barth, and R Kasznik 2003 Do firms manage stock-based compensation expense disclosed under SFAS 123? 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Wake Forest Law Review 35: 123-152 29 Voluntary disclosures that disavow mandatory disclosures: The case of stock options Table Sample Selection Firms listed on Execucomp for fiscal 2001 (8,699 executives) 2,507 Less: Firms with no 2001 Execucomp compensation data 1,025 Firms with 2001 Execucomp compensation data for the firm’s CEO 1,482 Less: Firms with missing stock option footnote data from EDGAR Firms with 2001 Execucomp and footnote data Less: Firms with other missing data from COMPUSTAT or CRSP and outliers Maximum number of sample firms examined in logistic regressions 140 1,342 26 1,316 30 Voluntary disclosures that disavow mandatory disclosures: The case of stock options Table Descriptive Statistics Panel A: Distribution of disavowals (n = 1,342) Type of disavowal Number of firms Firms with a disavowal that specifically questions the reliability of estimated stock option compensation expense (DISRELI) Firms with a disavowal related to the use of the Black-Scholes model (DISBS) Firms with a disavowal related to assumptions to estimate pro forma income (DISASS) Firms reporting at least one type of disavowal 191 Percentage of the sample 14.2% 232 17.3% 236 17.6% 248 18.5% Panel B: Descriptive statistics for other variables Standard 1st 3rd Minimum Maximum Mean Deviation Quartile Median Quartile Value Value Total Assets 13,034 56,786 565 1,662 6,092 32 1,051,450 SOCE 59.62 195.87 3.69 9.87 34.73 -62.58 3,480 SDSDRET 0.042 0.033 0.023 0.033 0.050 0.002 0.389 VOLRATIO 1.21 0.44 0.92 1.13 1.38 0.42 7.55 SOC% 43.50% 31.30% 14.14% 44.67% 69.97% 0.00% 100.00% CEOSO% 17.09% 22.11% 2.28% 10.12% 22.62% -43.21% 100.00% TOTAL COMP 6,653 16,985 1,251 2,762 6,673