Stock options have received a lot of bad press recently, especially back-dated stock options. If options were granted strictly as an incentive to increase performance by management, that would be one thing. Unfortunately, many times these benefits to management can come at the expense of the shareholders.
“My latest study shows that some managers have reduced earnings to miss important earnings targets in order to lower stock prices,” says Dr. Mary Lea McAnally, associate professor of accounting for Mays Business School at Texas A&M University. “What this does is make their option grants more valuable, but at the expense of shareholders. This earnings management is in addition to the backdating problems that we already know about.”
Smart Business discussed these findings with McAnally for further insight into how stock prices are affected.
How can granting stock options affect share prices and the shareholders?
Conventional wisdom is that managers do everything they can to increase earnings so that stock prices rise, their reputation is enhanced, their bonuses increase and the options they hold are more valuable.
But what is less obvious is the possibility that new stock option grants might entice managers to decrease earnings or even to miss earnings forecasts. The usual reaction to missed targets is a reduction of stock value, which lowers the strike price on new option grants. This is worse than backdating in some ways, because with backdating the managers just take advantage of stock price drops. What my study shows is that, in some cases, managers cause the stock price to drop.
What can be done to prevent or at least bring these actions into the open?
A company’s board of directors is its first line of defense. Boards need to be vigilant for earnings management or manipulation and, at a minimum, need to get answers when companies miss earnings targets.
While there have been some complaints about the cost and other negatives of Sarbanes-Oxley (SOX), one great benefit is the quicker and more complete disclosure of option grants. Section 403 requires registrants to report new stock option grants to the SEC within two business days. If a company reports bad news, like a missed earnings target, and then files a Section 403 report saying more stock options have been granted to key employees, that transaction is going to be noticed.
Another benefit of SOX is the requirement that audit committees have more financially literate members. These members can take a hard look at the timing of option grants, especially when earnings are disappointing.
Are there other benefits of SOX in these situations?
In general, I believe that the benefits of SOX have been misunderstood and perhaps undervalued relative to all the costs of complying with the new rules. For example, with audit committees having more financially savvy members, firms are making better financial decisions across the board, like better hedging choices and better financing decisions. Those benefits are hard to quantify, but at least one recent study finds that the stock market assigns a premium to companies with more literate members on the board and audit committee.
Some recent corporate implosions may have been exacerbated by weak boards with less oversight, and things just spiraled out of control. Before SOX, there weren’t always the proper controls that would enable or empower managers who wanted to do the right thing.
In the aftermath of the Enron and WorldCom meltdowns, accountants did take a lot of flak. One of the silver bullets of SOX is that accounting standard-setting and oversight have come under more scrutiny. Accountants have to be more on their toes and do a better job, and SOX gives them more authority. Auditors have to be more independent. And that’s a good thing because when push comes to shove with a client, auditors can point to SOX and use that as a stick. SOX is making auditors’ jobs somewhat easier and creating a bit of a boom time for the accounting profession.
What should a business do about stock options from this point forward?
Stock-based compensation is a good tool to motivate managers and get their incentives perfectly aligned with those of their shareholders. It would be a shame if companies stopped using options or restricted stock because of negative market perceptions created by the recent scandals. But the hope is that the actions by the SEC and states attorneys general will be a clarion call. There’s no substitute for well-written policies, board oversight and financial reporting transparency.
DR. MARY LEA MCANALLY is an associate professor of accounting and research fellow at Texas A&M University’s Mays Business School. Reach her at firstname.lastname@example.org.