Accelerated Vesting of Employee Stock Options in Anticipation of FAS 123-R

Accelerated Vesting of Employee Stock Options in Anticipation of FAS 123-R Preeti Choudhary Doctoral Student Fuqua School of Business, Duke University P.O Box 90120, Durham, NC 27708 Tel: 919 660 7906; Fax: 919 660 7971 email: pc27@duke.edu Shivaram Rajgopal Herbert O Whitten Endowed Professor University of Washington Business School Box 353200, Seattle, WA 98195 Tel 206 543 7913; Fax 206 685 9392 email: rajgopal@u.washington.edu Mohan Venkatachalam* Associate Professor Fuqua School of Business, Duke University P.O Box 90120, Durham, NC 27708 Tel: 919 660 7859; Fax: 919 660 7971 email: vmohan@duke.edu January 2007 Abstract: The Financial Accounting Standards Board (FASB) recently mandated the use of a fair value based measurement attribute to value employee stock options (ESOs) via FAS 123-R In anticipation of FAS 123-R, between March 2004 and November 2005, several firms accelerated the vesting of ESOs to avoid recognizing existing ESO grants at fair value in future financial statements We find that the likelihood of accelerated vesting is higher if (i) acceleration has a greater effect on future ESO compensation expense, especially related to underwater options; and (ii) firms suffer greater agency problems, proxied by fewer block-holders, lower pension fund ownership and top five officers holding a greater share of ESOs We also find a negative stock price reaction around the announcement of the acceleration decision, especially for firms with greater agency problems *Corresponding author We thank Raj Aggarwal, Jennifer Francis, Rebecca Hann, Ross Jennings, Chandra Kanodia, Bill Kinney, Ed Maydew, Partha Mohanram, Kevin Murphy, Karen Nelson, Doron Nissim, Terry Shevlin, Ross Watts, Greg Waymire, Joe Weber and workshop participants at the 2006 FARS Conference, Columbia University, Massachusetts Institute of Technology, University of California, Berkeley, University of Minnesota, University of Southern California, University of Texas at Austin and UNC/DUKE Fall Camp for many helpful suggestions on the paper We are grateful to Katherine Schipper for many helpful discussions We thank Carl Schmitt of Buck Consultants and Jack Cieselski of the Analyst’s Accounting Observer for sharing their data with us and thank Xin Wang for research assistance We acknowledge financial support from the University of Washington Business School and Fuqua School of Business, Duke University Accelerated Vesting of Stock Options in Anticipation of FAS 123-R Introduction In March 31, 2004, the Financial Accounting Standards Board (FASB) issued an exposure draft followed by a formal standard, FAS 123-R, on December 12, 2004 that required the use of a fair value based measurement approach for share based payments, including employee stock options (ESOs), effective June 15, 2005 Public firms were required to apply the new accounting rules to (i) all ESO awards granted after June 15, 2005; and (ii) ESO awards granted after 1994 but not vested as of June 15, 2005 The fair value based measurement approach for ESOs under FAS 123-R imposes financial reporting costs in that it entails recording compensation expense relating to both new option grants and existing unvested options In order to reduce or avoid financial reporting costs associated with FAS 123R firms could consider two (not mutually exclusive) alternatives With regard to compensation expense arising from (i) above, firms could avoid issuing new option grants after the effective date, i.e., June 15, 2005; with respect to (ii) above, firms could consider vesting all unvested options (i.e., accelerate the vesting) prior to the effective date In this paper we focus on accelerated vesting because it represents a short term, one time response to an accounting standard where the timing of the acceleration is indicative of intent to achieve a financial reporting objective Our enquiry into firms’ accelerated vesting decision is motivated by extant research that indicates managers take “real” actions in response to accounting standards to avoid or achieve a financial reporting outcome Real managerial actions could also result in wealth transfers either to or away from firm shareholders For example, Mittelstaedt, Nichols and Regeir (1995) report that a significant number of firms cut health care benefits after the passage of SFAS 106 which required financial statement recognition of health care costs Health care benefit reductions represent wealth transfers away from employees to shareholders In contrast, Carter and Lynch (2003) examine a managerial action that transfers wealth to employees Specifically, they investigate option repricing activity surrounding a 1998 The SEC postponed the implementation date of FAS 123-R by six months for calendar year companies However, this postponement will not affect firms whose fiscal year ends after June 15th Our sample ends with accelerated vesting announcements as of November 18, 2005 to allow enough time for data gathering and analysis FASB proposal that changed the accounting for option repricings In this FASB proposal, firms that reprice stock options after December 15, 1998 would record a compensation expense equal to the difference between the new exercise price and the market price of the stock in each future period the option is unexercised Carter and Lynch (2003) find that option repricing activity increased significantly during 12 days prior to the effective date, indicative of managers taking advantage of accounting rule changes to transfer wealth from shareholders to employees and themselves Our study complements Carter and Lynch (2003) by examining accelerated option vesting, a real action in response to an accounting standard that benefits the employees at shareholder’s expense However, our research differs from theirs in three ways First, in the repricing setting, there was no financial reporting consequence for firms’ past actions (i.e., prior option grants) or for firms that did not find it optimal to reprice; rather, firms faced financial reporting cost as a consequence of the new accounting rule only for subsequent option repricings In the accelerated vesting setting, firms that not accelerate the vesting of unvested options (i.e., nothing), would still face a financial reporting cost Second, unlike the repricing setting where the financial effects are not estimable due to unknown future prices, we are able to quantify the financial reporting costs for both accelerators and non-accelerators Consequently, we are able to document that the accelerated vesting decision is influenced by the level of financial reporting costs Lastly, we are able to quantify the wealth transfer from shareholders to employees through the significant negative stock price reaction surrounding the announcement of accelerated vesting decision We examine two questions First, we investigate what motivates some firms to alter their compensation contracts in response to an accounting standard, while others not In other words, we examine the characteristics of firms that accelerate the vesting of options prior to the effective date of FAS 123-R to evaluate the cost benefit tradeoff associated with the acceleration decision While the timing of the accelerated vesting decision suggests that it is driven by financial reporting benefits, there are other reasons to accelerate option vesting, including economic motivations such as (i) hastening the inflow of cash from option exercises if the firm is liquidity constrained, (ii) retaining employees and improve employee morale, and iii) transferring wealth from shareholders to managers due to poor governance and greater agency problems Acceleration is not costless to firms as it decreases the amount of service required of employees before enjoying the benefit from exercising the options Thus, we investigate whether the decision to accelerate is driven only by financial reporting motivations or by agency and economic motivations as well Second, we investigate whether the acceleration decision represents benign changes in employees’ compensation contracts in that it does not represent wealth transfers from shareholders to employees by examining the stock market response to this form of transaction structuring Our analysis is based on a sample of 355 firms that announced the accelerated vesting of options from March 2004 to November 2005 and a control sample of 665 firms We observe a rapid increase in the number of accelerated vesting announcements subsequent to the passing of SFAS 123-R indicative of managerial motivation to avoid recording a stock option expense Moreover, our results indicate that the likelihood that a firm accelerates ESO vesting is increasing in the extent of financial reporting benefits That is, firms that “save” more future stock option expense are more likely to accelerate, and firms with significant underwater options are more likely to accelerate We also find that accelerators are less likely to have voluntarily adopted the fair value provisions of FAS 123, as these firms already recognize option costs at fair value Although these voluntary adopters would enjoy the same reporting benefit of reduced future cost through acceleration, they will also record increased option costs at fair value at the time of acceleration whereas non-adopters would only record option costs at intrinsic value Finally, we find that firms active in the equity markets or with greater stakeholder claims are more likely to accelerate; we interpret this result as suggesting that these firms wish to manage the perceptions of investors and stakeholders such as customers, suppliers, and employees We not find much empirical support for arguments that cash constrained firms will accelerate to reap cash inflows on the exercise of the option or that firms whose stocks have under-performed relative to their industry are more likely to accelerate vesting in order to retain employees or to boost their morale Turning to agency motivations, we find that significant managerial ownership and greater option holdings by the top five executives are associated with accelerated vesting This is consistent with recent claims (e.g., Jensen, Murphy and Wruck 2004) that equity incentives induce managers to increase stock prices in the short run through income increasing financial reporting choices Conversely, we find that firms with better governance structures are less likely to accelerate vesting In particular, we find that firms with greater blockholder ownership and pension fund ownership (our proxies for better governance structures) have lower likelihood of acceleration, consistent with anecdotal reports that corporate consultants such as the Corporate Library (who advise institutions on how to vote on proxy proposals) criticizing accelerated vesting of options (The Washington Post, 2005) and the reluctance of active institutional investors to allow firms to reset or change the terms of employee stock options (e.g., The Wall Street Journal, 1999) Regardless of whether accelerated vesting is prompted by financial reporting motivations, agency factors, or a combination of the two, it is unclear ex ante whether the decision is value-increasing or value-destroying, on average Boards of several firms state that avoiding a future accounting charge via accelerated vesting is value-increasing because of the income statement effects: “The Board believes it was in the best interest of the shareholders to accelerate these options, as it will have a positive impact on the earnings of the Company over the previously remaining vested period of approximately years.” (Source: Central Valley Community Bancorp, 8k filed on February 23, 2005) However, investors may perceive accelerated vesting as merely paying employees more for a reduced amount of service, i.e., a wealth transfer to employees To investigate this issue, we examine the stock market response and find that the average market reaction to the acceleration decision is –0.98% over the five-day period surrounding the announcement We interpret this as the market perceiving accelerated vesting, on average, as a wealth transfer to employees The magnitude of the negative abnormal return is economically significant considering the average market reaction for news events such as extreme negative earnings announcements ranges between -1% and -1.5%, on average (see Jegadeesh and Livnat, 2005; Bernard and Thomas 1990) We also find that the negative reaction is larger for firms where the top five officers hold a greater proportion of stock options The results suggest that acceleration announcements are interpreted unfavorably by the stock market, especially when the market might perceive the wealth transfers to executives to be greater Our paper makes three contributions to the extant literature First, we provide archival evidence consistent with Graham, Harvey and Rajgopal (2005) and Nelson, Elliott and Tarpley (2002) who find that firm managers are willing to alter transactions (the terms of compensation contracts in this paper) to manage financial reporting We add to a small but growing stream of archival research that offers evidence of such behavior For example, Imhoff and Thomas (1988) document a substitution from capital to operating leases and non-lease sources of financing following adoption of FAS 13 Dechow and Sloan (1991) and Bushee (1998) provide evidence that managers reduce R&D spending to meet earnings goals Lys and Vincent (1995) show that AT&T spent between $50 million and $500 million to gain pooling ofinterests accounting in its acquisition of NCR Marquardt and Wiedman (2005) show that the likelihood of firms issuing contingent convertible bonds, which are often excluded from diluted EPS calculations under FAS 128, is significantly associated with the reduction that would occur in diluted EPS if the bonds were traditionally structured Second, we contribute to the literature that examines the real effects of accounting standards where one effect of transaction structuring is the wealth transfer from shareholders to employees Unlike prior research (e.g., Carter and Lynch (2003)), we find that agency factors contribute as much as financial reporting reasons to motivate the accelerated vesting decision We are also able to document the wealth transfers as measured by the stock market reaction around the announcement date Finally, our results indicate that the stock market is not misled by managers’ attempts to structure transactions for achieving favorable financial reporting outcomes and transferring wealth to employees and themselves Rather, our data suggest that the stock market recognizes the wealth transfers to employees, in particular, wealth transfers to top executives, and reflects such wealth transfers via lower stock prices The remainder of the paper is organized as follows Section discusses the background and hypotheses Section describes the data and empirical results related to factors associated with the likelihood that a firm will accelerate the vesting of options Section presents evidence related to our tests relating to abnormal returns at the acceleration announcement Section summarizes and concludes Background and Hypotheses 2.1 Background Prior to 2005, the accounting for share based payments, including options issued to employees (ESOs), was governed by FAS 123 and Accounting Principles Board (APB) Opinion 25 This opinion was issued in 1972, one year before the Black-Scholes (1973) option valuation model was published APB 25 specifies that the cost of fixed-plan stock option compensation is based on the intrinsic value of the option (excess of the market price over the exercise price) on the option grant date Most firms reported no option related compensation expense by issuing at-the-money options For these options, the intrinsic value at the grant date is zero However, at-the-money options have substantial economic value as measured by fair value using valuation methods such as Black-Scholes or binomial models In October 1995, the FASB issued FAS 123 requiring firms to disclose (not recognize) a fair-value-based estimate of ESOs.2 Accounting irregularities in 2001 and later years gave rise to a widespread perception that excessive stock option grants caused managers to manipulate accounting numbers and shore up stock prices to lock in gains on their exercisable stock options (e.g., Bartov and Mohanram 2004, Cheng and Warfield 2004; Burns and Kedia 2005, and Bergstresser and Phillipon 2005) In an effort to restore investor confidence, several companies voluntarily adopted the fair value measurement provisions of FAS 123 Furthermore, in February 2004, the International Accounting Standards Board issued a standard that required companies using international accounting standards to value stock options using fair value measurement in their financial statements The FASB issued FAS 123-R in December 2004 FAS 123-R requires recognition of the cost of share based payments using a fair value based measurement (as opposed to the intrinsic value under APB 25) on the grant date The cost of the award is FAS 123 also states that the preferred treatment is recognition of the cost of share based payments using a fairvalue-based measurement spread over the vesting period FAS 123-R was originally scheduled to be effective for public companies after June 15, 2005 The SEC postponed the implementation date of FAS 123-R on April 14, 2005 stating that SEC registrants will have to comply with FAS 123-R beginning with the first interim or annual reporting period of the first fiscal year beginning on or after June 15, 2005 - i.e., the first quarter of 2006 for most public companies.3 Under FAS 123-R, all stock options awarded to employees that vest (become exercisable) after the effective date must be valued and recognized using a fair value method Options already vested (even if unexercised) prior to the effective date are not affected as the required services for those options have already been rendered For example, if a calendar year public company granted an option to an employee on December 31, 2003 that vests (i.e., is exercisable) ratably over three years, a third of the award will vest in fiscal 2006, i.e., after the effective date of FAS 123-R Under FAS 123-R that company will record the fair value (measured at the grant date) of the vested options as a compensation expense in fiscal 2006 However, that company can mitigate this cost by accelerating the vesting of the final third of the award to a date on or before December 31, 2005 SEC Professional Fellow, Chad Kokenge, stated on December 6, 2004 that firms choosing to accelerate vesting of stock options must not only disclose any and all modifications to outstanding awards but also must provide the reason for accelerating the vesting We rely on these disclosures to identify 355 firms who accelerated vesting of unvested stock options as of November 18, 2005 While most firms appear to accelerate vesting of underwater options, 65 of our sample firms voluntarily reported that they accelerated the vesting of some in-the-money options as well 2.2 Motivations for accelerated vesting One of the objectives of the paper is to investigate the motivations for accelerating the vesting period of ESOs prior to FAS 123-R’s effective date We identify three factors: (i) accounting; (ii) While calendar-year companies receive a six-month reprieve, several technology companies (e.g., Cisco, JDS Uniphase, Sun Microsystems) and other companies with fiscal year-ends in June 30th and July did not benefit from this delayed implementation economic; and (iii) agency factors that we hypothesize to influence this decision We discuss them in turn, and describe the measurement of variables that we use to proxy for these factors Accounting factors 2.2.1 Extent of underwater options While a firm’s acceleration decision reduces financial reporting costs by avoiding future option expense, it requires recording a current option expense at the time of acceleration depending on the moneyness of the accelerated options Under APB 25 if the vesting period of an ESO is shortened (i.e., vesting is accelerated) the ESO will be revalued and recorded as an expense based on the intrinsic value at the acceleration date.4 Consequently, accelerating the vesting period of in-the-money options that have positive intrinsic values entails incurring a compensation cost at the acceleration date Accelerating the vesting period of at or out of the money stock options, however, requires no option expense recognition at the acceleration date because the intrinsic value is zero at that date Hence, we hypothesize that the probability that a firm accelerates vesting is greater if the firm has more under-water options Our empirical proxy for the extent of underwater options is obtained from the Execucomp database, which contains detailed data on option grants to the top five officers of the firm We estimate the extent of underwater options for the entire firm by dividing the number of options granted to the top five executives by the proportion of options granted to these executives relative to that granted to all employees For firms that were not in Execucomp, we hand collected option grant data and percentage of options granted from the annual proxy statements We follow Hall and Knox (2004) and compute the percentage of unvested options held by the senior officers that are underwater as of December 2004 (the latest date for which the Execucomp database is available) We assume that the top five executives’ options vest over four-years and calculate the proportion of unvested options that are underwater as a percentage of shares outstanding For example, all options granted in 2001 through 2004 are considered unvested for an officer of a firm with fiscal year ending in December 31, 2004 To determine whether the A firm that had voluntarily adopted the fair value provisions of FAS 123 would recognize the fair value of those options at the time of acceleration Data on option grants for the year 2004 are not available in the Execucomp database for 162 of our treatment firms For those firms we hand-collect option information from proxy statements granted options are underwater we compare the strike price of the option to the stock price of the firm as of December 31, 2004 (for acceleration firms we use the stock price at the end of the day before acceleration) We then scale the estimate of the total number of underwater options by shares outstanding and label the variable UNDER% We expect the probability of accelerating the vesting period to increase with UNDER%.6 The hypothesized positive association between accelerated vesting and UNDER% has another interpretation under the view that accelerating the vesting of underwater options has a positive effect on employee morale and perhaps provides incentives for employees to stay with the firm To disentangle this morale explanation from a desire to reduce financial reporting expense, we consider another variable that captures the likelihood that managers will make efforts to retain employees in section 2.2.7 2.2.2 Future expense saved Over 60% of the accelerating firms cite the magnitude of the future expense avoided as one of the key benefits of accelerating the vesting of options That is, by accelerating the vesting date, firms will avoid recognizing any future option cost Hence, we predict firms are more likely to accelerate when these future costs are larger We discuss three reasons why managers might undertake actions to affect income that has no cash flow effects First, Graham, Harvey and Rajgopal (2005) find that several CFOs they interviewed believe that stock markets are efficient, on average, but they would rather not take the chance that the market inefficiently prices reported income of their firms Second, recent findings in Sloan (1996) and Xie (2001) question market efficiency with respect to the pricing of earnings components For example, Hirshleifer and Teoh (2003) model an equilibrium in which partially attentive investors might attend more to recognized rather than disclosed charges to income The existence of such investors might create incentives for firms to keep future accounting costs off the financial statements Finally, even if the stock market is efficient at unraveling the effects of structuring transactions on reported income, managers might manage reported income to signal their competence to the managerial Because Execucomp contains data from company proxy statements (which follow fiscal years), the entries show the number of options at the end of the company’s fiscal year, not calendar year 10 Cremers K.J.M, and V.B Nair 2005 Governance Mechanisms and Equity Prices Journal of Finance (forthcoming) Dechow, P., A Hutton, and R Sloan 1996 Economic Consequences of Accounting for Stock Based Compensation Journal of Accounting Research 34:1-21 Dechow, P., and R Sloan 1991 Executive incentives and the horizon problem: An empirical investigation Journal of Accounting and Economics 14:51-89 Dlugosz, J., R Fahlenbrach, P Gompers and A Metrick 2004 Large Blocks of Stock: Prevalence, Size, and Measurement, Working Paper, University of Pennsylvania Economist, The 2002 How to pay bosses (November 14) Espahbodi, H., P Espahbodi, Z Rezaee and H.Tehranian 2002 Stock Price Reaction and Value Relevance of Recognition versus Disclosure: The Case of Stock-based Compensation Journal of Accounting and Economics 33 (2002) 343–373 FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) Accounting for Stock-Based Compensation FASB Statement No 123 Norwalk, CT: FASB, 1995 FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) Accounting for Stock-Based Compensation (Revised) FASB Statement No 123-R Norwalk, CT: FASB, 1996 Francis, J and K Schipper 1999 Have Financial Statements Lost their Relevance? Journal of Accounting Research 37: 319-353 Graham, J., C Harvey and S Rajgopal 2005 The Economic Implications of Financial Reporting Journal of Accounting and Economics (forthcoming) Greene, W 1993 Econometric analysis 2cd edition MacMillan Publishing Company, New York Hall, B and T A Knox 2004 Underwater Options and the Dynamics of Pay-to-Performance Sensitivities Journal of Accounting Research 42: 365 Himmelberg, C and R G Hubbard, 2000 Incentive Pay and Market for CEOs: An Analysis of Pay-forPerformance Sensitivity Working paper, Columbia University Hirshleifer, D and S H Teoh 2003 Limited Attention, Information Disclosure and Financial Reporting Journal of Accounting and Economics 36(2003): 337-386 Hodder, L., W Mayew, M McNally, and C Weaver 2006 Employee Stock Option Fair-Value Estimates: Do Managerial Discretion and Incentives Explain Accuracy? Contemporary Accounting Research (forthcoming) Hodge, F., S Rajgopal and T Shevlin 2005 How Managers Value Stock Options and Restricted Stock? Working paper, University of Washington 32 Imhoff, E and J Thomas 1988 Economic Consequences of Accounting Standards: The Lease Disclosure Rule Change Journal of Accounting and Economics 10: 277-310 Jensen, M.C., K Murphy and E Wruck Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them Working paper, Harvard Business School Jones, J 1991 Earnings management during import relief investigations Journal of Accounting Research 29, 193-228 Kedia, S and S Rajgopal 2005 Geography and the Incidence of Financial Misreporting Working paper, Rutgers Business School and University of Washington Kokenge, Chad (Professional Accounting Fellow, Office of Chief Accountant of the U.S Securities Exchange Commission) Speech given at the AICPA National Conference on Dec 6, 2004, www.sec.gov/news/speech/spch120604cak.htm Lys, T., and L.Vincent An Analysis of Value Destruction in AT&T’s Acquisition of NCR Journal of Financial Economics 39 (1995): 353–78 Marquardt, C; and C Wiedman 2005 “Earnings Management through Transaction Structuring: Contingent Convertible Debt and Diluted EPS.” Journal of Accounting Research, 43: 205-243 Matsumoto, D 2002 Management’s Incentives to Avoid Negative Earnings Surprises Accounting Review 77: 483-515 Matsunaga, S.R and C.W Park 2001 The Effect of Missing a Quarterly Earnings Benchmark on the CEO’s Annual Bonus Accounting Review 76: 313-332 McConnell, P D Mott, J Pegg, and C Senyak Employee Stock Options: Over 400 Companies Accelerate Stock Options’ Vesting Bear Stearns, Nov 21, 2005 McConnell, P D Mott, J Pegg, and C Senyak FASB Does It: FAS 123(R) Requires Stock Option Expensing Bear Stearns, Dec 16, 2004 Mittelstaedt, F, W Nichols and P Regier 1995 SFAS No 106 and Benefit Reductions in EmployerSponsored Retiree Health Care Plans The Accounting Review 70, 535-556 Murphy, K 2000 Performance Standards In Incentive Contracts Journal of Accounting and Economics 30: 245-278 Nelson, M., J Elliott, and R Tarpley 2002 Evidence from Auditors about Managers’ and Auditors’ Earnings Management Decisions The Accounting Review 77: 175-202 Oyer, Paul 2004 Why Firms Use Incentives that have No Incentive Effects? Journal of Finance 59, 1619-1649 Pollock, T.G., H Fisher and J Wade 2001 The Role of Politics In Repricing Executive Options Academy of Management Journal Scharfstien, D and J Stein 1990 Herd Behavior and Investment The American Economic Review 80: 465-480 33 Sloan, Richard 1996 Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? Accounting Review 71: 289-316 Smith, C., and R Watts 1992 The Investment Opportunity Set and Corporate Financing, Dividend, and Compensation Policies Journal of Financial Economics 7: 117-61 The Street com 2005 Midnight At the Options Oasis April 12 Trueman, Brett 1986 Why Manager’s Voluntarily Release Earnings Forecasts? Journal of Accounting & Economics 8: 53-72 Xie, Hong 2001 The Mispricing of Abnormal Accruals The Accounting Review 76: 357-374 Wall Street Journal, The 1999 Breathing underwater: Amid Shareholder Complaints, Companies Look for Alternatives to Repricing Options, April 8, p R6 Wall Street Journal, The 2005 Estimates Will Come in Two Flavors: Thomson First Call to List Profit Predictions Including and Excluding Option Cost, September 15, p C3 Washington Post, The 2005 Pushing fast-forward on options Speeded-up vesting is a way around new accounting rule, but some cry foul December 19, 2005; D01 Warfield, T.D., J J Wild, and K.L Wild 1995 Managerial Ownership, Accounting Choices, and Informativeness of Earnings Journal of Accounting and Economics 20(1): 61-91 Watts, R L., and J L Zimmerman 1990 Positive Accounting Theory, A Ten Year Perspective The Accounting Review 65: 131-156 Whaley, R E Derivatives: Markets, Valuation, and Risk Management, Manuscript The Fuqua School of Business, Duke University (2005) Zang, A 2005 Evidence on the Tradeoff Between Real and Accruals Manipulation Working Paper, Duke University 34 Figure Time series trends in Accelerated Vesting Announcements 35 Table Variable Definitions and Data Sources Variable Measurement Data Source UNDER% Total number of options held by Top executives that are out of money scaled by shares outstanding EXECUCOMP where available otherwise hand collected BHAR_INDADJ One year industry adjusted buy and hold return (Firm return – corresponding industry return) CRSP and www.yahoo.com IMPACT After tax income effect of accelerating out-of-the-money and in-the-money options Execucomp, Press releases, 10K, 10Q, 8K, CRSP, Equilar data ADOPTER EQ_ISSUE MEET_BEAT Dummy variable =1 if firm voluntarily expenses options, otherwise Dummy variable = if firm issued equity in the past years, otherwise % times firm has met or exceeded prior year same quarter net income in past 12 quarters Bear Stearns Report 4/28/2004 COMPUSTAT COMPUSTAT 36 Notes Out-of-the-money determined by comparing exercise price to December 31, 2004 price for control firms and to the price the day before acceleration in the case of firms that accelerate Options that are granted in years 2001 through 2004 are assumed to be unvested For firms that accelerated in 2004 (2005) returns are computed over the year ending June 2004 (December 2004) For control firms, returns are computed over the calendar year 2004 Industry returns are computed based on three-digit NAICS code matching after excluding the firm for which industry return is computed Some accelerating firms disclose the income statement effect For firms that not disclose and for the control firms we compute after tax income effect by determining the Black Scholes value (see Whaley [2005]) of the unvested underwater options Assume options issued in past years are unvested and issued at the money Input assumptions to Black Scholes are taken from a database purchased by Equilar, collected from annual 10K fillings When data is missing, we calculate input assumptions using a year assumed holding term, Year T-Bond rate, dividend rate = 0, and volatility computed from a minimum of 30 months price data from CRSP We sum ẳ of 2001, ẵ of 2002, ắ of 2003, and all of 2004 options to determine outstanding expense We find a correlation of 0.72 for firms that disclose impact and our calculated impact Value = if firm voluntarily adopted FAS 123-R (is currently or intends to start expensing options as of May 2004) as of 2004 Firm is assumed to have issued equity if DATA108 > Table (continued) Variable LOSS D/E STCLAIM Measurement Percentage of times in the last years the firm had a loss after deducting the option expense amount disclosed in the 10K Total debt / Market value of equity A single factor determined from three variables: 1) dummy indicator for durable goods industry 2) R&D/Sales 3) labor intensity (1-PPE/ adjusted total assets); D_CAPITAL If FCF