Option Expensing and Executive Compensation

Yi Feng, Yisong S. Tian
2007 Social Science Research Network  
This paper examines the impact of mandatory option expensing on executive compensation. Using CEO compensation data from 1993 to 2004, we document a sharp reversal in the use of option incentives around 2001 while the use of stock incentives increases throughout the entire period. Median CEO option incentives increases 25% a year before 2002 but declines 18% a year after 2001. We argue that this sharp reversal is related to the recent change in option expensing rules. First, we develop a
more » ... we develop a principal-agent model that incorporates the impact of option expensing on executive compensation. The executive's perceived cost of option expensing alters the optimal contract and leads to a reduction in equity incentives, option incentives in particular. This theoretical result provides a rational explanation for the documented decline in the use of option incentives. Secondly, we find evidence that the decline in option incentives is larger in firms using excessive levels of equity incentives prior to option expensing than in control firms. This is consistent with the expected impact of option expensing across firms with different levels of equity incentives prior to option expensing. Thirdly, firms make similar reductions to option grants made to the CEO, other top executives and lower-level employees, again consistent with the expected impact of option expensing. Finally, we find that other regulatory, business and market events that coincide with the change in option expensing rules such as the Sarbanes-Oxley Act of 2002, the option backdating scandal, and the 2000 stock market crash contribute to but do not fully explain the documented decline in option incentives.
doi:10.2139/ssrn.970662 fatcat:drh6xi6o7za4nnnzplazxvnz4a