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 / First Quarter 1997 / Issue 6(originally published by Booz & Company)


Stock-Based Compensation and the Cost of Capital

Increased Cost of Capital

The key argument in opposition to the expensing of options is that it would increase the cost of raising debt and equity capital.

The argument hinges on the idea that investors form their expectations of the future performance of a company by naïvely relying on reported earnings. Therefore, a new accounting rule that reduces reported earnings is supposed to cause investors to revise their expectations downward. This, in turn, is supposed to increase the cost of borrowing and the cost of equity capital.

But this is fatuous. If investors simply took the time to understand the rules underlying the computation of earnings, then their expectations would not be influenced by mere changes in those rules.

Yet even if investors' expectations are naïvely tied to reported earnings, the case for expensing options can still be made. As long as it is agreed that granting options transfers value from the company to the employees, then expensing their cost produces a more relevant earnings number.

That is the view of Warren E. Buffett, the noted billionaire and corporate chieftain, who supported the proposal to expense options.

"I'll make [an offer] to any executive who is granted a restricted option, even though it may be out of the money," he wrote in the 1992 annual report to stockholders of his holding company, Berkshire Hathaway Inc. "On the day of issue, Berkshire will pay him or her a substantial sum for the right to any future gain he or she realizes on the option. So if you find a C.E.O. who says his newly issued options have little or no value, tell him to try us out."

Should the cost of capital in certain industries be subsidized? We won't take sides on that issue. However, allowing companies not to record an expense for options does not appear to be the most direct or effective way of providing this subsidy. It is also an inequitable way, since naïve investors who do not understand the true cost of stock option awards end up paying the subsidy.

To examine the validity of the cost-of-capital argument, we performed three sets of empirical tests.1

First, we examined whether companies requiring additional outside capital are more intensive users of stock options. In our look at the financing habits of the 4,000 publicly traded companies, we found no evidence that companies requiring additional financing used more executive stock options to boost earnings.

Second, we examined the stock price reactions of companies using options when they made announcements relating to the expensing proposal. We looked for a reduction in the stock price around these announcements on the basis that sophisticated investors would bid the price down because naïve investors would no longer be fooled by artificially inflated earnings. But we found no evidence of such price moves. Despite the claims of management that companies would be decimated by the new proposal, the stock market simply did not react.

Third, we examined the characteristics of the companies that lobbied against the proposal to determine whether they needed additional financing. What we found was that the 348 companies that expressed criticism to the accounting board were among the most cash rich in the country.

Overall, we therefore found no direct evidence to support the cost-of-capital argument.

Accountability for Top Executive Compensation

In the early 1990's, when the proposal to expense options was introduced, the country was in a recession and the compensation of top executives was under scrutiny from the media and politicians. The amount of that compensation was frequently criticized in the press for being "excessive" and "not linked to performance."

The proposal to expense stock options provided a methodology for valuing and reporting the grants that were being made to top executives.

"FASB's proposal, if it becomes final, would place a reasonable check on executive pay packages which contain options -- a check which up until now has been missing," Senator Carl Levin, Democrat of Michigan, was quoted as saying in the Chicago Tribune in 1993.

The computation and recognition of an expense associated with stock options would provide further ammunition for lobbying against excessive executive compensation, supporters of the proposal said. Moreover, the computation and recognition of a cost for this form of compensation could provide a basis for imposing taxes and other wealth transfers on top executives.

We researched this alternative view of the accounting board's proposal by examining the characteristics of the 348 companies that lobbied against it. For the purpose of comparison, we also collected data on a sample of control companies, matched by industry and size, that did not submit comment letters opposing the proposal.

Through a detailed analysis of financial and proxy statements, we compared the two groups of companies in terms of their policies on top executive compensation. The results, summarized in the accompanying exhibit, demonstrate that executives who opposed the proposal have higher total compensation and receive a greater proportion of that compensation in the form of option grants.

Exhibit I

Compensation for Executives Opposing Expensing of Stock Options Compared with a Control Group 

Source: Journal of Accounting Research

Even more striking is the fact that the top executives of companies opposing the proposal use option compensation most aggressively for themselves as compared with other employees in their firms. The average number of options received by a top executive for every one option received by a lower-level employee was 709 in the opposition sample and 438 in the control sample.

Broader Implications

While corporate America appears to have won its battle to block the changes in accounting for employee stock options, the effectiveness of the regulatory process has been undermined in the process.

In theory, accounting information exists to provide investors with relevant data concerning the financial condition of a business enterprise. This includes providing an earnings number that has had compensation costs deducted from it. In practice, though, corporate America represents a major force in the accounting regulatory process.

If corporate management successfully used its lobbying muscle to protect its own interests, rather than to provide stockholders with relevant information, then the regulatory process is simply not performing its intended purpose.


1 For more details on the tests discussed here, see "Economic Consequences of Accounting for Stock-Based Compensation," a forthcoming article in the Journal of Accounting Research, Spring 1997, Volume 35, written by the same authors.

Patricia M. Dechow, Patricia M. Dechow is aprofessor of accounting at the Wharton School of the University of Pennsylvania.
Richard G. Sloan, Richard G. Sloan is a professors of accounting at the Wharton School of the University of Pennsylvania.
Amy P. Sweeney,

Amy P. Sweeney is a professor of business administration at the Harvard Business School. All three have Ph.D.'s from the University of Rochester.

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