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

Preeti Choudhary
Doctoral Student
Fuqua School of Business, DukeUniversity
P.O. Box 90120, Durham, NC27708
Tel: 919 660 7906; Fax: 919 660 7971
email:
Shivaram Rajgopal
Herbert O. Whitten Endowed Professor
University of WashingtonBusinessSchool
Box 353200, Seattle, WA98195
Tel. 206 543 7913; Fax 206 685 9392
email: / Mohan Venkatachalam*
Associate Professor
Fuqua School of Business, DukeUniversity
P.O. Box 90120, Durham, NC27708
Tel: 919 660 7859; Fax: 919 660 7971
email:

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, DukeUniversity.

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

1. 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 123-R 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.[1]

Our enquiry into firms’ accelerated vesting decision is motivated by extant research that indicates managers take “real” actions in response toaccounting 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) examinea managerial action that transfers wealth to employees. Specifically, they investigate option repricing activity surrounding a 1998 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 daysprior to the effective date, indicative of managers taking advantage of accounting rule changes to transfer wealth from shareholders to employees and themselves. Our study complementsCarter 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 subsequentoption repricings. In the accelerated vesting setting, firms that do not accelerate the vesting of unvested options (i.e., do 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 do 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. Whilethe timing of the accelerated vesting decision suggests that it is driven by financial reporting benefits, there are other reasons to accelerate option vesting, includingeconomic 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 enjoyingthe 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 examiningthe stock market responseto 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 announcementssubsequent 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” morefuture stock option expenseare 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 recordincreased 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 do 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 3 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 of-interests 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 theaccelerated 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 2 discusses the background and hypotheses. Section 3 describes the data and empirical results related to factors associated with the likelihood that a firm will accelerate the vesting of options. Section 4 presents evidence related to our tests relating to abnormal returns at the acceleration announcement. Section 5 summarizes and concludes.

2. Background and Hypotheses

2.1Background

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 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 notaffected 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-Rthat companywill 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) 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.