Halting the Stock Option Express:

A Comprehensive Evaluation of the Impact of Expensing Options on Stock Price and Company Performance

University Scholar Proposal

My fascination with the stock market began when I was eight years old and my Dad told me about a special vehicle that allowed him to make money without exerting much work effort. Recognizing my captivation with the market, my Dad enlisted me as his secretary and gave me the task of listing the closing prices of various stocks on the NYSE and NASDAQ. I distinctly recall the feeling of excitement and anticipation that overwhelmed me as I watched the symbols move on the tickers, with the aspiration of having the knowledge and expertise to become a successful investor someday in the future. I was enthralled by the stock market at this early age, and my passion for it still burns strongly. For several years, I have grappled with this intriguing prospect, trying to uncover the secrets behind this amazing phenomenon. Looking back, I realize that my Dad oversimplified the process. In order to reap the benefits of the stock market, investors must do a lot of research, but the basic proposition of making money on money, still holds true.

Today, as I reflect on my childhood memories, I feel that I have endured a loss of innocence. My image of the stock market has been marred by the onslaught of corporate scandals and greed. This summer I was appalled by the incessant revelations of accounting debacles in trusted and well known companies such as Enron, Global Crossing, Tyco, and WorldCom. In the wake of these numerous corporate scandals, I observed in disbelief as public zeal for accounting reform ignited and placed intense scrutiny on the accounting profession, auditing practices, and regulation procedures. Specifically, many experts have concluded that the accounting treatment for stock options played an integral role in contributing to the infectious greed that swept America, by allowing corporations to conceal the costly dilutive effects of stock options. For example, semiconductor giant Intel is among the most vocal opponents of the new movement to expense stock options. Like many technology companies, Intel doled out a large amount of stock options, which if expensed would have decreased its 2001 earnings from $1.3 billion to $254 million (Clark, B1).

In his new book Take on the Street, former SEC chairman, Arthur Levitt, recounts that in retrospect, he feels that his "biggest mistake" was pushing FASB to surrender its plans to implement a rule that would force corporations to expense their stock options. He recalls the political lobbying and debate that surrounded the 1993 FASB proposal. Senator Lieberman was outspoken in his disapproval of the FASB proposal warning that expensing options would have "grave consequences for American entrepreneurs" (Levitt, 75). According to Levitt, the failure of the FASB to implement its 1993 proposal enabled executives to "use accounting tricks to boost the share price upon which their compensation depended" (Levitt, 76).

As an accounting student soon entering the profession, I am troubled by the lack of trust and visibility in corporate financial statements, which is critical for the health and stability of our capitalist economy. I believe there is an urgent need to restore integrity, reliability, and transparency of financial statements, which are the foundations for the accounting conceptual framework. I agree that stock options are a powerful mechanism that can serve as a source of motivation for chief executives and a tool to align their interests to those of the shareholders. However, like leading economists, I think that the accounting treatment for stock options played an integral role in festering the greed that pervades the corporate world. Executives gained handsomely when their shares surged during the bubble market of the 1990s, often regardless of how well they performed their jobs. How could executives make so much while their shareholders lost fortunes? Whats wrong with the existing financial reporting system, and how can it be fixed? Did companies that took the initiative to expense their stock options fare better than those who did not? These are among the questions I hope to address through the completion of my University Scholar Project.

I propose a comprehensive analysis of stock option accounting methods and an investigation into reforming the tax laws to curtail their abuse. Specifically, I would like to perform an event study around the announcement date of firms that voluntarily decided to change their accounting method for stock options. I will survey approximately seventy companies that have recently announced that they will begin expensing their stock options, by extracting information from their public disclosures. This list which I obtained from the Standard & Poors web-site includes bellwether companies like General Electric, Citigroup, Coca-Cola, General Motors, Procter & Gamble, JP Morgan-Chase, and many others.

Using scatter diagrams and other statistical techniques I will examine how the public disclosure of changes in accounting methods used for stock options affect stock prices. To calculate the residual price change, I will use regression analysis and extract the influence of relevant industry specific and market-wide factors (Beaver, 89). I will then compare these results to industry specific control groups consisting of firms that have already been expensing options. For example, my control group for the airline manufacturing industry will include Boeing. In addition, I will calculate the earnings response coefficient which measures the magnitude of the relationship between stock returns and earnings surprises around the time of corporate earnings announcements. This will enable me to test my hypothesis that there is an industry specific correlation between the rate of return on stock prices and the announcement to expense options or stay with the status quo.

In addition to the event study, it is necessary to examine the tax consequences of stock options. Even as the seemingly salutary trend of expensing options gains momentum, I do not think this will be enough to dispel investors fears. However, if coupled with effective tax reforms, investors may get a more realistic sense of the impact of stock options. It is for this reason that I would like to investigate the effect of implementing tax penalties on companies that make excessive option grants, similar to the rule in place for salaries that exceed $1 million dollars. I will survey the effect of reducing or eliminating the tax benefit received when stock options are exercised for firms that do not currently expense their options. I am planning to utilize corporate financial statement disclosures and findings regarding the implementation of the existing $1 million maximum salary deduction rule.

The idea of decreasing the tax deduction firms receive related to stock option expense was originally proposed in 1993 by Senators Levin and McCain under the "Corporate Executives Stock Option Accountability Act" (Brenner, A20). After failing to pass the act in 1993, these two senators have revised their initial recommendation and are now proposing the "Ending Double Standards for Stock Options Act" which suggests limiting the tax deduction for stock option compensation to the amount expensed on the financial statements. I will examine the effect of this new proposal on the firms I include in my project, by calculating the additional tax corporations would have to pay if they lost their stock option deduction. Exploration into these topics will give me a solid background upon which I can evaluate possible sources of effective tax reform.

In regard to event study and financial aspects of my project, I am privileged to have the assistance and support of Professor Teitel, who has a wealth of knowledge in financial reporting and related issues. In fact, I am currently working on a research paper with her in my ACCT 202 class that involves performing a chronological analysis of the events leading to the passage of SFAS 123 and gaining insight into the process of private-sector standard setting. This will undoubtedly serve as the foundation for my University Scholar project and open doors for new ideas and areas of research. I am also fortunate to have the cooperation of Professor Phillips whose expertise in corporate taxation will be invaluable in researching the tax implications of congressional proposals and existing SEC regulations. Furthermore, I have contacted Professor Golec in the finance department, who has offered to help me understand the Black-Scholes pricing model and the ramifications of the assumptions used to calculate compensation expense.

In regard to collecting the data necessary to complete the queries I have outlined, I will use the databases available through the Homer Babbidge Library including LexisNexis Academic, CCH Internet Tax Research Network, Dow Jones Interactive, and Standard & Poors, as well as information gathered from SEC filings. In addition, I will refer to articles from scholarly accounting publications like the Accounting Horizons and to general business publications like the Wall Street Journal, Business Week, Fortune, and Barrons.

My focus for next semester will be to complete the remainder of my mandatory general business classes including MKTG 201 and OPIM 204C. In its coverage of ethics and the relationship between corporations and the legal system, BLAW 275 will give me the necessary background to help me understand how the SEC interacts with firms. Furthermore, the Professor Schragers emphasis on ethics and the difference between the letter and the spirit of the law will help me appreciate the moral dilemmas executives encounter.

During the summer, I plan on participating in an internship with an accounting firm. Although my free time will be limited, I would like to take at least one summer class. This will ease my course load for my remaining two semesters and allow me to devote more time and attention to the development of my project. Having my summer tuition fees waived would be a tremendous relief, and enable me to attain my academic pursuits without being inhibited by financial constraints.

In Fall 2003 I plan on enrolling in either FNCE 202 of 204, both of which focus on risk return analysis and its influence on the decision making involved in buying and selling stocks and options. This will be helpful in preparing my event study and calculating the earnings response coefficient. I will also be taking ACCT 296W, since I am planning to use my University Scholar project to double as my honors thesis.

* Classes that are relevant to the completion of my University Scholar Project

** I may supplement either my Fall 2003 or Spring 2004 semester schedule with

MGMT 276- Compensation Analysis and Administration

During my final semester, I plan on taking Assurance Services which will give me valuable insight into audit risk analysis. Through case studies I will enhance my critical thinking skills and apply them to practical business situations. I am also considering enrolling in one graduate class in either the accounting or finance department. Finance 303 is the only course in the School of Business that directly addresses stock options, and I think this class will provide me a thorough understanding of stock option valuation methods. The graduate Research in Taxation class will be of great practical use because it will give me guidance on how to sift through large quantities of tax data and identify pertinent information. I have been given permission to enroll in accounting and finance graduate classes in connection with my University Scholar project, if I feel that it is necessary to supplement my curriculum with more rigorous courses.

The downfall in the stock market and recent revelation of corporate wrong doings has heightened the controversy on the estimation and disclosure of stock options in financial statements. The University Scholar program will give me the flexibility and resources to enrich my accounting curriculum with extensive knowledge about a topic that is highly relevant in todays economic environment. Although I am currently being introduced to the topic of stock option accounting in two classes, my existing plan of study will not give me the breadth of knowledge I desire regarding this subject matter. If accepted into the University Scholar program, I will be able to enroll in courses outside the scope of my major, and make arrangements with my professors to supplement my classes with additional material related to stock options. Not only am I passionate about this topic, but the knowledge I obtain through this experience will serve as the foundation for obtaining my Masters degree, prepare me for the CPA exam, and assist me throughout my career in public accounting.

Works Cited

"Arthur Levitts Crusade." Rev. of Take on the Street. Business Week Sept. 2002:74-80.

Beaver, William H. Financial Reporting: An Accounting Revolution. New Jersey:

Prentice Hall, 1998.

Brenner, Reuven. "Another Option on Options." The Wall Street Journal 30 Sept. 2002:

A20

Clark, Don. "Contrary Intel Wont Expense Options." The Wall Street Journal 8 Aug.