The Pricing and Determinants of the Discretionary Component of Employee Stock Option Value

1. The Pricing and Determinants of the DiscretionaryComponent of Employee Stock Option Value Chii-Shyan Kuo Department of Quantitative Finance College of Technology Management National Tsing Hua University (Taiwan)

2. Outline • Research question • Literature review • Data and research design • Empirical results • Conclusions National Tsing Hua University (Taiwan)

3. Research Question • Whether the discretionary employee stock option (ESO) value improves or impairs the value relevance of ESO value? • Whether the discretionary ESO value for overstating firms accounts for the pricing effect of ESO value? • What are the possible determinants for this pricing effect? National Tsing Hua University (Taiwan)

4. Literature review (1): • Value relevance of the ESO value. • Managerial discretion over option model input assumptions. • Information communication vs. opportunistic manipulation perspectives. National Tsing Hua University (Taiwan)

5. Literature review (2):Value relevance of the ESO value • Negative pricing effect: • Aboody (1996) find a negative relation between stock price and outstanding employee stock option value. • Aboody et al. (2004) find a negative relation between disclosed ESO expense and share price. • Positive pricing effect: • Rees and Stott (2001) find that the disclosed ESO expense in 1996 is positively associated with stock returns. • Bell et al. (2002) find a positive relation between stock price and disclosed ESO expense for a sample of 85 profitable computer software firms. National Tsing Hua University (Taiwan)

6. Literature review (3): Managerial discretion over option model inputs • Yermack (1998) find that Fortune 500 companies apparently use the flexibility to reduce the CEO stock option value by an average of 8.9%. The understatement of option value is associated with the degree to which CEO receive excessive pay. • Balsam et al. (2003) find small, newly public firms, and firms that provide high levels of CEO pay or stock option compensation allocate a small portion of the option value to the 1996 pro forma expense. • Bartov et al. (2004) find that firms’ reliance on forwarding-looking information is limited to situations when this reliance results in lower option expense. In addition, firms opportunistically understate volatility when their option holdings are relatively large. National Tsing Hua University (Taiwan)

7. Literature review (4): Managerial discretion over option model inputs • Aboody et al.(2006) also find that the underestimation of option value is increasing in the size of expense, is greater for firms with weaker corporate governance, and is increasing in the excessiveness of executive pay. • Johnston (2006) find that firms voluntarily recognize option expense manage that expense downward more than firms do not recognized option expense. • Hodder et al. (2006) find that, on average, firms choosing assumptions that underestimate ESO values have incentives to manage earnings and disguise the size and value of compensation package. In contrast, firms that overestimate ESO values appear to convey information about future operating risk. National Tsing Hua University (Taiwan)

8. Literature review (5):information vs. opportunism incentive • Information communication perspective (Watts and Zimmerman 1986, Healy et al. 1993, Subramanyam 1996, Ahmed et al. 2000, Sanker et al. 2001): flexibility afforded by GAAP facilitates efficient contracting and improve private information communication through financial reports. • Opportunistic manipulation perspective (Healy et al. 1993, DeAngelo et al. 1994, Burgstahler et al. 1997, Burgstahler et al. 2006, Teoh, Welch, and Wong 1998, Guidry et al. 1999): flexibility allows managers to opportunistically manipulate financial reports, as evidenced by a large earnings management literature. National Tsing Hua University (Taiwan)

9. Data National Tsing Hua University (Taiwan)

10. Descriptive statistics National Tsing Hua University (Taiwan)

11. The grant-date value of ESOs in the S&P 500, 1992-2002 Poitras (2004) –Executive Stock Option Disclosure: Is FAS 123 Adequate? National Tsing Hua University (Taiwan)

12. Expected input assumptions National Tsing Hua University (Taiwan)

13. Pricing effect test (1): OLS National Tsing Hua University (Taiwan)

14. Why IV (2SLS)? National Tsing Hua University (Taiwan)

15. Pricing effect test (2):2SLS National Tsing Hua University (Taiwan)

16. Pricing effect test (3): 2SLS National Tsing Hua University (Taiwan)

17. Pricing effect test (4): OVER vs. UNDER National Tsing Hua University (Taiwan)

18. Pricing effect test (5): consistently overstating vs. understating firms National Tsing Hua University (Taiwan)

19. Additional test (1):SP on 10-k filing date National Tsing Hua University (Taiwan)

20. Additional test (1):Correlation analysis National Tsing Hua University (Taiwan)

21. Additional test (2):Regression of alternative measures of FVDISC on deviations of input assumptions and their expected ones National Tsing Hua University (Taiwan)

22. Additional test (3):pricing effect tests National Tsing Hua University (Taiwan)

23. Determinants of the discretionary ESO value National Tsing Hua University (Taiwan)

24. Conclusions: • I examine whether the discretionary ESO value improves or impairs the value relevance of ESO value and whether the discretionary ESO value accounts for the pricing effect of ESO value. • Overall, the evidence supports that the discretionary ESO value can improve the value relevance of ESO value. More importantly, the pricing effect is mainly attributable to the underestimation rather than overestimation of ESO value. • One possible interpretation is that, in addition to managerial opportunism, the information incentives could also motivate managers to exercise their discretions to under-report their ESO value, thereby signaling lower level of firms’ future operating or financial risk to outside investors. Additional tests show that this result is unlikely driven by measurement errors. National Tsing Hua University (Taiwan)