Areexecutivestockoptionsassociatedwithfuture

JournalofAccountingandEconomics36(2003)3–43Areexecutivestockoptionsassociatedwithfutureearnings?$MichelleHanlona,ShivaramRajgopalb,TerryShevlinb,*aUniversityofMichiganBusinessSchool,AnnArbor,MI48109-1234,USAbDepartmentofAccounting,UniversityofWashingtonBusinessSchool,Box353200,Seattle,WA98195-3200,USAReceived28February2002;receivedinrevisedform20December2002;accepted31October2003AbstractWeestimatetherelationbetweenstockoption(ESO)grantstothetopfiveexecutivesandfutureearningstoexaminewhetherincentivealignmentorrentextractionbytopmanagersexplainsoptiongrantingbehavior.ThefutureoperatingincomeassociatedwithadollarofBlack-ScholesvalueofanESOgrantis$3.71.Tounderstandthesourceofthesepositivepayoffs,weparseoutESOgrantvaluesintocomponentspredictedbyeconomicdeterminantsofoptiongrants,governancequality,andaresidualgrantvalue.ThepayoffstoESOsappeartobedrivenpredominantlybytheeconomicdeterminantsofoptiongrantsandnotpoorgovernancequality.r2003ElsevierB.V.Allrightsreserved.JELclassification:G30;J33;M41Keywords:Managementcompensation;Stockoptions;Incentivealignment;RentextractionARTICLEINPRESS$HanlonacknowledgessupportfromaDeloitteandTouchefellowshipandanErnstandYoungfellowship.RajgopalacknowledgesfinancialassistancefromtheFuquaSchoolandtheAccountingDevelopmentFundattheUniversityofWashington.ShevlinacknowledgessupportfromboththeAccountingDevelopmentFundandDeloitteandTouche.Wethankananonymousreferee,ThomasLys(theeditor),DaveLarcker(thediscussant),MaryBarth,BobBowen,DaveBurgstahler,DawnMatsumoto,SteveMatsunaga,JamesMyers,EdRice,GimSeow,MohanVenkatachalamandotherworkshopparticipantsattheUniversityofWashington,BostonAccountingResearchConsortium(BARC),HarvardBusinessSchool2002ConferenceonInformation,MarketsandOrganizations,the2002StanfordSummerCampandtheJAEConferenceforhelpfulcommentsonthepaper.WethankPaulGompers,JoyIshiiandAndrewMetrickforgraciouslyagreeingtosharetheircorporategovernancedata.*Correspondingauthor.Tel.:[phone];fax:[phone].E-mailaddress:[e-mail](T.Shevlin).0165-4101/$-seefrontmatterr2003ElsevierB.V.Allrightsreserved.doi:10.1016/j.jacceco.2003.10.0081.IntroductionInthispaper,weassesswhetherandhowtheBlack-Scholes’valueofstockoptionsgrantedtothetopfiveexecutivesrelatestofutureoperatingearnings.Althoughstockoptionscomprisethefastestgrowingcomponentoftopmanagementcompensation,thereisnoconsensusontherelationbetweenemployeestockoptioncompensationandfuturefirmperformance.Thislackofconsensuscanbedistilledintotwoopposingperspectives.Theincentivealignmentperspectivetypicallyadvocatedbyanumberoffinancialeconomistsstatesthatoptionsaregrantedtoreducethemoralhazardproblemthatstemsfromseniormanagersowningverylittleofthefirmstheymanage.AsubstantialbodyoftheoreticalworkbeginningwithJensenandMeckling(1976)suggeststhatoptioncontractscanalignmanagers’incentiveswiththatofshareholders.Consistentwiththisperspective,researchers(e.g.,DemsetzandLehn,1985;Himmelbergetal.,1999;CoreandGuay,1999;RajgopalandShevlin,2002)havepredicatedtheiranalysesonthepremisethatgrantingoptionsisconsistentwithfirmvaluemaximization.Asecondperspective,popularespeciallyamongshareholderrightsactivistsandorganizedlabor,isthatseniormanagerscontrolthepay-settingprocessandcompensatethemselvesinexcessoftheleveloptimalforshareholders(welabelthisviewastherentextractionperspective).Someresearchersarguethatoptionsareaninefficientwaytocompensatemanagers(Jenter,2001;Meulbroek,2001;HallandMurphy,2002;LambertandLarcker,2002).Othersclaimthatstockoptionsdonotexhibitempiricalrelationsconsistentwiththeeconomicmotivationsbehindgrantingthem(e.g.,Yermack,1995)andmayevenbeapoliticallyexpedientwayofcloakingseniormanagers’payassuchcompensationisgenerallynotrecordedinthefirms’financialstatements(e.g.,Crystal,1991).Researchershavealsopresentedevidencethatmanagersabuseoptiongrantsfortheirownbenefit(e.g.,Yermack,1997;AboodyandKasznik,2000;CarpenterandRemmers,2001;Bensetal.,2002).Werefertothisastherentextractionhypothesis.Toexaminetheseconflictingperspectives,weestimatewhetherafirm’sBlack-Scholesvalueofnewemployeestockoptionsgrantedtoitstopfiveexecutivesisassociatedwithfutureoperatingearnings.Oursamplecomposes2,627firm-yearobservationsfromyears1998to2000andESOgrantsfrom1992to2000fromS&PExecucompdatabase.Inourbaseregressions,whichadjustforsimultaneitybiasusinganindustryinstrumentalvariablesapproach,wefindthatadollaroftheBlack-Scholesvalueofanoptiongranttothetopfiveexecutivesoftheaveragefirmisassociatedwithfutureoperatingincome(undiscounted)overthenext5yearsofapproximately$3.71.Thepositiverelationisinconsistentwithpervasiverentextraction.SpecificationtestssuggestaconcaverelationbetweenESOgrantvaluesandfutureoperatingincome(thepositiverelationisincreasingbutatadecreasingrate).WefindthatassumingalinearrelationbetweenESOgrantvaluesandfutureearnings(asdoneinpriorstudies)mightresultinmisleadinginferencesaboutthenatureofthepayofftooptiongrants.Becausetheconclusionsaresomewhatsensitivetowhetherthemodelassumeslinearornon-linearrelationbetweenfutureARTICLEINPRESSM.Hanlonetal./JournalofAccoun