How does the US equity market react to domestic and international stock-based compensation accounting changes?

Academy of Accounting and Financial Studies Journal, Jan, 2008 by Feng-Shun "Leo" Bin, Leonard Branson, Dar-Hsin Chen

ABSTRACT

This study examines US equity market performance surrounding the announced changes in rules that account for employees' stock-based compensation plans in a corporation. We found the stock market in general reacted negatively to the issuance of SFAS 123 and its preceding exposure draft, but the observed abnormal returns were insignificant. SFAS 148 amended SFAS 123, and a 2004 exposure draft (ED) proposed additional revisions. The updated treatment of stock based compensation generally caused positive but insignificant pronouncement effects. The insignificance of price reactions to the issuance of SFAS 148 or the ED was not sensitive to a firm's size, domesticity, disclosure requirement, exchange-listing regulation or industry sector.

When the US Congress took legislative action which threatened FASB's independence and authority on the SBC accounting policy issues, the stock market reacted unfavorably, except for those foreign-based ADR-issuing firms. We also report on the market response to the latest international developments in "share-based payment" accounting reforms, including IASB's IFRS 2.

INTRODUCTION

The American and global financial accounting policy makers have been striving to improve the financial disclosures of publicly traded firms to provide better information to investors. This need for continuous improvement in accounting standards has led to ongoing updates to General Accepted Accounting Principles (GAAP). Around the world, stock-based compensation (SBC) plans have become increasingly popular for firms that attempt to tie their employees' rewards to performance. These compensation methods continue to change as firms attempt to find better ways to tie compensation to performance. The most recent developments include General Electric's introduction of "performance share units" in September 2003 that replaced the traditional stock options and restricted stocks granted to the firm's top executives (The Wall Street Journal, "For GE Chief Immelt, Stock Options Are a Thing of the Past," September 18, 2003, Pages B1 and B3). Correspondingly, how to update the accounting treatment for various SBC packages has been drawing increased public attention, particularly since the early 1990s.

This study examines the price performance of the US stock market when the Financial Accounting Standards Board (FASB) announces updates of US GAAP that concern firms' financial statement disclosures of their employees' SBC. Existing studies have largely focused on the interim or long-term association between stock price and stock option expense, yet few published works have examined the possible instant wealth effects associated with the pronouncements of employee stock option (ESO) accounting changes. Do the shifts in the disclosure environment regarding firms' stock options cause any new "information shocks" that might materially affect the investing public's valuation of equities of firms affected by SBC accounting changes?

Our work investigates a time frame that ranges from mid-1993 to mid-2004, in which the FASB struggled to develop and adopt Statement of Financial Accounting Standard (SFAS) No. 123 and later amended it with SFAS No. 148. While the FASB was experiencing difficulties in finalizing its requirements, the International Accounting Standards Board (IASB) experienced more success by issuing International Financial Reporting Standard (IFRS) No. 2 in less time and with much less opposition.

RECENT SBC ACCOUNTING DEVELOPMENT

During the development of SFAS 123 in the early 1990s, the FASB was constantly pressured by the competing interests of the investing public (e.g., Warren Buffet), of ESO-granting industries and firms (e.g., Silicon Valley Coalition and the American Electronic Association), of reporting practitioners (e.g., The Big Six public accounting firms), and of the US Congress (e.g., U.S. House of Representatives). The investing public was concerned about the high corporate compensation paid to top executives that was not justified by the firm performance. ESO-granting industries and firms felt the only way they could attract and retain top management talent was by the use of ESO. Due to the effective lobbying of business executives, the US House of Representatives got directly involved and reversed the accounting regulators.

Young (1997) and Miller, Redding and Bahnson (1998) describe in detail the due process of SFAS 123, which eventually lead to FASB's compromise solution to "encourage, rather than require, recognition of compensation cost based on a fair value method and pursue expanded disclosures." (SFAS 123, Paragraph 378) "The Board chose a disclosure-based solution for stock-based employee compensation to bring closure to the divisive debate on this issue 3/4 not because it believes that solution is the best way to improve financial accounting and reporting." (SFAS 123, Paragraph 62)

The SBC accounting issue faded away but did not die. Public concern grew dramatically following the stock market decline and a series of corporate financial scandals that occurred in the early 2000s. Investors blamed the existing financial accounting practices, which include SBC reporting rules, for being ineffective. According to Hitt and Schlesinger (2002), "In 2000, Enron issued stock options worth $155 million, according to a common method of valuing options. Had accounting rules forced the company to deduct the cost of those options from its 2000 profit, according to New York brokerage firm Bear Stearns Cos., Enron's operating profit for the year would have been 8% lower, even before Enron made its drastic restatement of earnings several months ago. But current rules require companies to report the cost of issuing options only as a footnote in their annual reports.