Options Reporting and the Political Costs of CEO Pay

Abstract

Managers' systematic influence on accounting policy is well documented in the earnings management literature. Recent studies in the “management of information” line of research suggest that such influence is exhibited in financial reporting more generally, including supplemental disclosures in proxy statements. Using 1996 compensation data, I extend recent research on how firms report the value of options paid to their CEOs. I conduct several tests of the argument that potential political costs of unexplained compensation explain cross-sectional variation in how aggressively firms report option awards. Even after incorporating several variables not considered previously, I find strong support for the assertion that firms whose CEOs receive unexplained pay relative to performance tend to report lower grant date values for their CEOs' option awards. The evidence also suggests that the tendency to report lower grant date values is stronger for firms under more scrutiny from institutional owners. Contrary to previous research, I find that unexplained pay also increases the likelihood that the firm will choose grant date reporting methods (over the allowable alternative) in their proxy disclosures. I interpret the overall results as consistent with the argument that political costs related to compensation influence options reporting. The findings have implications for accounting standard-setters and for researchers who rely on estimates of option values reported in proxy statements.

Do firms understate stock option-based compensation expense disclosed under SFAS 123?

“…The regression explains 61% of the variation in CEO compensation. This explanatory power is the same as that of the analogous equation in Baker (1999) and considerably more than the 16% for the three-factor model in Yermack (1998). 25 Execucomp estimates the value of options granted to top executives by assuming, for all stock options, an expected life of 70% of contractual life, stock price volatility estimated over the past five years, dividend yield estimated over the past three years, and risk-free interest rate measured over the past seven years.…”

“…Our proxy for excessive executive pay is RESCOMP. Following Murphy (1996), Yermack (1998), andBaker (1999), RESCOMP is the residual from a regression of total annual CEO compensation on proxies for firm size, performance, growth, risk, and industry membership, as described in the Appendix. Our proxy for corporate governance is based on the governance score compiled by the IRRC.…”

“…25 Execucomp estimates the value of options granted to top executives by assuming, for all stock options, an expected life of 70% of contractual life, stock price volatility estimated over the past five years, dividend yield estimated over the past three years, and risk-free interest rate measured over the past seven years. 26 We do not include some proxies for human capital and agency conflicts that Baker (1999) and Core et al (1999) use because of lack of data availability and our much larger sample. Our inferences are insensitive to including two of these proxies for which data are available, i.e., CEO tenure with the firm and CEO stock ownership.…”

“…Thus, exercising discretion relating to expected forfeitures can alter the timing of SFAS 123 expense across periods within the vesting period. We do not consider discretion with respect to expected forfeitures because neither they nor whether the firm incorporates them are publicly disclosed and, therefore, available to us.9 Lewellen, Park, and Ro (1995),Murphy (1996),Yermack (1998), andBaker (1999) find evidence consistent with firms understating in their proxy statements estimated values of options granted to the firm's CEO, particularly when the CEO receives more compensation than predicted by compensation models.Do firms understate stock 435…”

Remuneration Committee, Board Independence and Top Executive Compensation

“…According to the rule, each firm discloses only the upper and lower bounds of 7 To test our hypotheses, we need to control for the effects of CEO pay determinants which can affect the CEO pay level but are irrelevant to our research questions. Therefore, in our model specification, we include economic determinants of top executive pay, including firm growth potential, operating risk, firm size and firm performance [34][35][36].…”