An Empirical Analysis of the Tax Benefit from Employee Stock Options. Tippie College of Business, University of Iowa, Iowa City, IA 52242

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1 An Empirical Analysis of the Tax Benefit from Employee Stock Options Michael Cipriano a, Daniel W. Collins a, Paul Hribar* b a Tippie College of Business, University of Iowa, Iowa City, IA b Johnson Graduate School of Management, Cornell University, Ithaca, NY Preliminary. Comments Welcome First Draft: September 17, 2001 * Corresponding Author. Tel: (607) Fax: (607) address: sph24@cornell.edu. We appreciate the helpful comments of Jan Barton, Sudipta Basu, Julia D Souza, and Charles Lee.

2 An Empirical Analysis of the Tax Benefit from Employee Stock Options Abstract This paper examines how the market values the tax benefit that arises from employees exercises of non-qualified stock options. EITF requires that the tax benefit from employee stock options be included in the operating section of the statement of cash flows, effective July, We begin by documenting the magnitude of this operating cash flow component for a sample composed of S&P 100 and Nasdaq 100 member firms over the past 4 years. We examine the correlation between the tax benefit component of cash from operations and accruals, and compare this to the correlation between other components of cash from operations and accruals. Finally, we examine the relation between stock returns and changes in the tax benefit, to see if the market prices changes in the tax benefit consistent with changes in earnings and other operating cash flows. Our results show that for our limited sample of firms, the tax benefit is a large and growing component of cash from operations. Unlike other components of cash from operations, however, it exhibits no relation with current or past accruals and is instead related to current and past stock returns. Finally, stock returns appear to be negatively related to the tax benefit from employee stock options when we explicitly control for the endogeneity between returns and the tax benefit. This latter result is consistent with previous stock options research that documents a negative association between prices and options, and suggests that the wealth transfer effect of the stock options dominates the cash benefit received from lower corporate taxes. 1

3 1. Introduction This paper presents an in-depth empirical analysis of the tax benefit from employee stock options. The use of stock options to compensate employees at all levels continues to increase in popularity (Cohn 1999, Epstein, 1999, Mehran and Tracy 2001). If the stock option plan is structured as a non-qualified plan, the difference between the strike price and the market value of the underlying stock is treated as ordinary income to the employee at the exercise date. Thus, the firm receives a tax deduction equal to the compensation expense claimed by the employee. We refer to the reduction in taxes payable from this transaction as the tax benefit from employee stock options. Under APB 25, Accounting for Stock Issued to Employees and FAS 123, Accounting for Stock Based Compensation, typically no compensation expense is recognized on the income statement from the issuance of employee stock options. Accordingly, any tax benefit that the firm receives from the exercise of these options is also not recognized on the income statement. Because the tax benefit represents a cash inflow (or reduction in cash outflow) to the firm, however, it needs to be accounted for in the statement of cash flows. Recently, the FASB has decided that this tax benefit is appropriately classified as an operating cash flow (EITF 00-15). Accounting for the tax benefit associated with employee stock options has engendered considerable debate. First, some have challenged the appropriateness of classifying the tax benefit as an operating cash flow. Since the tax benefit has not been recorded as part of income, classifying the tax benefit as an operating cash flow runs counter to the logic of FAS 95 which states that operating cash flows are generally the cash effects of transactions that enter into the determination of net income (paragraph 21). The tax benefit is directly linked to a financing activity -- the issuance of equity and no cash flow occurs absent this event. Thus, it can be argued that the tax benefit is more akin to a financing cash flow, and should be construed as part of the cash that firms receive in exchange for the shares that are issued. 2

4 Second, the amount of the tax benefit is largely determined by actions outside of managers immediate control, most notably the firm s stock returns and employees desire to exercise their options. Thus, it is likely to be more transitory than other operating cash flows, and less related to the core operations of the firm. Showing this tax benefit in the operating section introduces a highly transitory component to cash flow from operations that can easily mislead the unwary investor. Third, for successful firms with large employee stock option plans, the tax benefit can be economically significant. For example, Cisco s annual report for fiscal 2000 reports that operating cash flows were $6.14 billion, for the year ended July 31, Of that $6.14 billion, however, $2.45 billion was attributable to the tax benefit from employee stock options. Without the tax benefit, cash from operations would have been $3.65 billion, or 41% lower. Although Cisco represents an extreme example, it highlights the fact that total cash from operations can be greatly impacted by the inclusion of this item. And while Cisco explicitly labels this item in their statement of cash flows, this is not true of all companies. Hence, it often requires a more detailed examination of other parts of the financial statements to determine the cash flow attributable to the tax benefit. At a minimum, investors must be able to recognize the difference between traditional cash from operations and the tax benefit from employee stock options. Treating the tax benefit as a permanent component of operating cash flow is likely to upwardly skew a discounted cash flow valuation. As the use of stock option plans continues to grow, the magnitude of the tax benefit will also grow, adding to its economic significance and the need to explicitly consider this item. Because the tax benefit is always positive, reported cash from operations is always increased by the inclusion of this item. The objective of this study is to understand the relation between stock prices and the tax benefit from employee stock options. The tax benefit represents an interesting financial statement analysis item, because of its classification in the operating section of the statement of cash flows. In particular, a firm s operating cash flows are enhanced when employees exercise options at a price that is below the market value of the shares. The greater the difference between the exercise price and the market price, the greater the 3

5 amount of the tax benefit. In essence, this treatment implies that the greater the wealth transfer to the employees, the better will be the firm s operating cash flows. This association is counter-intuitive, in that valuation principles suggest unexpected increases in operating cash flows will be associated with positive stock returns. Because we expect that the implicit cost of compensating employees associated with the tax benefit will outweigh the positive cash inflow, we predict a negative association between annual stock returns and the tax benefit. We begin our investigation by reporting the magnitude of tax benefit from employee stock options and examining the trend in the amount of tax benefit received over the past four years. This analysis highlights substantial growth in the tax benefit and the level of economic significance it attained during a relatively bull market. We also demonstrate that, unlike other cash from operations, the tax benefit is unrelated to current and past accruals and is instead related to current and past stock returns. This relationship runs counter to the logic that cash flows are the determinant of returns (and not vice versa), and introduces an endogeneity problem. Because of this endogeneity, our final analysis uses a simultaneous equations approach to examine the impact of the tax benefit on the firm s stock price. We document a negative relation between changes in the tax benefit and contemporaneous returns. This result is consistent with other stock options research that documents a negative association between prices and options (e.g. Aboody 1996, Aboody et al. 2001), except that our result is at the date of the exercise, suggesting that additional information is reflected in the realized value of the options exercised. 2. Background Information The vast majority of companies do not recognize compensation expense from the issuance of stock options in the income statement (Scholes et al. 2000). For nonqualified stock option plans, the employee is taxed on the difference between the exercise price and the market price at the date of exercise as ordinary income. Accordingly, the company receives a deduction for tax purposes. To be consistent with the treatment of the option-based compensation, the FASB prohibits companies from recognizing this tax benefit in the income statement if the associated compensation expense has not been 4

6 recognized in income. Herein lies the dilemma: the income tax benefit received by the company does not impact tax expense for financial reporting purposes, but the cash impact of the tax savings must be accounted for in the statement of cash flows. Prior to the issuance of EITF 00-15, companies had no explicit guidance as to where this benefit should appear on the statement of cash flows. Without guidance, companies exhibited substantial diversity in classifying and disclosing the tax benefit (EITF Issue Summary 00-15). Some companies classified the tax benefit as an operating cash flow while others classified it as a financing cash flow. For a number of companies it was difficult, if not impossible, to determine the amount and the classification of the income tax benefit in the statement of cash flows (EITF Issue Summary 00-15). EITF addressed the appropriate treatment of the cash flow associated with the tax benefit from employee stock options. Three options were considered: placement in the operating section, placement in the financing section, or allowing firms to make their own determination of the appropriate classification. Proponents of placing the tax benefit in the operating section argued that this treatment was consistent with the treatment of income tax expense. Additionally, for firms using the direct method, income taxes paid is included as a separate line in the operating section. Because the tax benefit reduces the cash outflow, it was argued that taxes paid in the operating section would be greater than the amount actually paid if the tax benefit was included in the financing section. Proponents of placing the tax benefit in the financing section, noted that stock options are irrevocably linked to the issuance of equity. Thus, they constitute a form of owner financing, and cash flows related to stock options are rightly treated as financing cash flows. A comment letter by Microsoft dated July 18, 2000, supports this position by citing FAS 123, Paragraph 228 that states: The amount of stock-based compensation that is deducted on the tax return may exceed the compensation cost recognized for financial reporting. This Statement requires that the tax benefits for deductions in excess of compensation cost be recognized as additional paid-in capital when the are initially recognized. The Board agrees with the conclusion 5

7 of the Accounting Principles Board in Opinion 25 that the additional tax benefits are attributable to an equity transaction (p.1, emphasis in original) After deliberating the issue, the EITF reached a consensus, ruling that the tax benefit was appropriately classified as an operating cash flow. Effective for fiscal periods ending after July 20, 2000, EITF requires companies to include the tax benefit triggered by the exercise of non-qualified employee stock options as an operating cash flow. Moreover, EITF requires explicit disclosure of a material tax benefit if it is not included as a separate line in either the statement of cash flows or the statement of changes in stockholders equity. Recent articles in the popular press address the treatment of the tax benefit from employee stock options as an operating cash flow (e.g. Weiss 2000, Fox 2001). For example, Weiss (2000) cautions investors to be wary of the impact of stock option exercises on cash from operations, stating [the tax benefit cannot] be counted on with any regularity and is dangerously linked to two things that management has no control over stock price and the desire of employees to convert their options into cash (p.3). As an example of the impact of classifying the tax benefit as an operating cash flow, consider the case of Cisco Systems. Exhibit 1 shows an abbreviated statement of cash flows for Cisco, for fiscal 1999 and Exhibit 1. Cisco Fiscal 2000 Simplified Statement of Cash Flows Net Income $2,023 $2,668 Net changes in working capital $673 $(651) Depreciation Expense $489 $863 Tax benefit from employee stock options $837 $2,495 Other Accruals $348 $766 CFO $4,325 $6,141 CFO excluding tax benefit $3,488 $3,646 6

8 Cisco s statement of cash flows shows that they have generated substantial tax savings from the exercise of stock options, growing from 19% of their cash from operations in 1999 to 41% of their cash from operations in Although the size of Cisco s stock option program and the increase in their stock price are atypical of the average firm, the Cisco example highlights the potential magnitude of this single component of operating cash flow. This example also serves to illustrate the ability of the tax benefit to mask deteriorating cash flows. For example, unadjusted cash from operations increased substantially from $4,325 in 1999 to $6,141 in This represents an increase of 42%, which compares favorably to the 32% increase in net income. Excluding the tax benefit, however, reveals that cash from operations increased from $3,488 to $3,646, an increase of only 4.5%, relative to the 32% increase in net income. Thus, the interpretation of Cisco s internal cash generating ability changes significantly depending on whether or not the tax benefit is included as part of operations. 3. Sample Selection Because the Cisco example likely represents an extreme example, our first goal is to document the magnitude of the tax benefit for limited sample of firms. We use two different indices to form our sample: the Standard and Poor s 100 (S&P100) and the Nasdaq 100. The Nasdaq 100 is chosen because firms in this index tend to be younger, more technologically intensive, and heavier users of options than firms in the S&P100. Inclusion of the Nasdaq 100 firms is likely to increase the statistical power of the tests by maximizing the size of the tax benefit. The S&P100 firms are chosen to provide a more balanced view of the universe of firms. Since Standard and Poor s chooses firms from various industries, it has a more diverse membership than the Nasdaq 100 sample. The S&P100 sample gives us a sample that might be more representative of the market as a whole, which provides a contrast between the two indices regarding the impact of the tax benefit. The sample used in this study consists of firms included in either the Nasdaq 100 or the S&P 100 indices as of December 31, This results in an initial sample of 193 firms, as seven firms are included in both indices. Because of differences in the statement of 7

9 cash flows, we eliminate thirteen firms in the Financial Services industry, which reduces the initial sample to 180 firms. One problem with using this sample is that the included firms suffer from a survivorship bias. Since the changes in the indices are correlated with market capitalization, the set of 180 firms included in the indices on December 31, 2000, on average, have outperformed the month-ending composite of the indices over the prior three years. However, we do not examine the time series behavior of the returns, only cross-sectional relations between returns and financial statement data. Table 1 provides some descriptive statistics on the sample firms, including size, beta, market-to-book ratio, net income, and cash from operations. As expected, the S&P firms tend to be larger, more profitable, and have lower beta and market-to-book factors than the NASDAQ firms. The tax benefit from employee stock options is collected from the annual 10-K filings filed with the SEC, for fiscal years 1997 through EITF requires that firms disclose a material tax benefit in either the statement of stockholders equity, the statement of cash flows, or the notes to the financial statements. 1 Despite this requirement, for several firms with non-qualified stock option plans, we were unable to ascertain the value of the tax benefit. 2 These observations are coded as missing and excluded from the tests. Other instances arose where the firm did not appear to have a significant stock option plan, or the firm did not have taxable income and could not take advantage of the tax benefit associated with the option exercise. In both cases no tax benefit was disclosed in the financial statements. These observations are retained in the sample and the tax benefit is recorded as zero. We collect other financial statement data from the Compustat database, and returns data from CRSP, via FactSet. We exclude the years where earnings, total assets, or cash from 1 In less than 5% of firm-year observations, the item was only able to identified in a supplemental disclosure to the Statement of Cash Flow and/or the stock options footnote disclosure. 2 Typically, it appeared as though the firm had aggregated the tax benefit with the proceeds from the exercise of stock options, and included the total as a separate line in the statement of stockholders equity. 8

10 operations are unavailable from Compustat and years where complete returns data are unavailable on CRSP. These sample selection criteria result in a sample of 479 observations. In order to accurately measure the cash from operations excluding the tax benefit prior to July 2000, we identified whether the tax benefit was classified as operating, financing, or not realized as a cash flow in the current period. 3 In cases where the tax benefit is explicitly labeled on the statement of cash flows, this determination is straightforward. For cases where the tax benefit is not explicit on the statement of cash flows, we compare prior years 10-Ks to the 10-K filed after EITF became effective, to determine whether the prior classification was as a financing or an operating cash flow. 4 Table 2 documents the magnitude of the tax benefit for all the firm-years in our sample. Panel A reports the dollar amount of the tax benefit, Panel B reports the tax benefit as a percentage of total cash from operations for firms with positive cash flow, and panel C reports the tax benefit as a percentage of book value of equity. 5 The mean tax benefit across all observations is just under $100 million. There is a noticeable time trend in the data, with the average tax benefit increasing from $31 million in 1997 to $161 million in Moreover, there is considerable skewness in the distribution, with over 25% of the firms reporting no tax benefit. Thus, the median level of the tax benefit falls considerably below the corresponding mean. Recall that firms reporting no tax benefit can represent at least two different circumstances: either the firm has a stock option plan but no taxable income (e.g. Amazon), or the firm does not have a material tax benefit 3 See Hanlon and Shevlin 2001 for situations when all or some of the tax benefit will not be included anywhere in the Statement of Cash Flows. 4 Because 10-Ks filed after July 2000 require retroactive classification of the operating cash flow including the tax benefit, we are able to compare these amounts to the cash flow statement in prior years 10-ks, and examine changes in the cash from operations from year to year. In the case where cash from operations changes between years, we check whether the restatement equals the amount of the tax benefit to ensure that the impact is due to the reclassification of the tax benefit. 5 The requirement that firms have positive cash from operations for percentages in Panel B eliminates 26 observations from the sample. 9

11 from their option plan (e.g. General Motors). One-quarter of the firms report a tax benefit greater than $115 million in fiscal As a percentage of cash from operations, the mean (median) increases from 7.77% (3.24%) in 1997 to 31.79% (6.63%) in Across all firm years, firms in the upper quartile report a tax benefit that constitutes at least 15.1% of their total reported cash from operations. In fiscal 2000, one-quarter of the firms in the sample derived more than a quarter (26.8%) of their operating cash flow from the tax benefit. Similar trends are evident in Panel C, where the tax benefit is reported as a percentage of the book value of equity. Table 3 repeats the analysis in Table 2 with the firms partitioned by index membership. As expected, the impact of the tax benefit is more economically significant among the Nasdaq 100 firms than it is among the S&P100 firms. Although the average level of the tax benefit is actually higher among the S&P100 firms than the Nasdaq 100 firms ($167.7 million versus $104.5 million), this is due to the overall larger size of these firms. As a percentage of cash from operations, the average for the Nasdaq sample increases from 7.8% in 1997 to over 46% in Moreover, half of the observations in the Nasdaq 100 report a tax benefit that constitutes more than 18% of their total cash from operations. For the observations in the S&P100 sample, the tax benefit as a percentage of cash from operations is considerably smaller. The average tax benefit increases from 2.6% of operating cash flows in 1997 to 12.27% in The median tax benefit, however, is only 1% of the cash from operations, and the upper quartile is 4.5% of cash from operations. In summary, the descriptive statistics reveal that the tax benefit has been growing in magnitude over the past few years and is economically meaningful, particularly for firms in the technology sector. This is undoubtedly due to a combination of factors, including the rise of non-qualified stock option plans in recent times and the bull market over the sample period. Going forward, the use of stock option plans is likely to continue to grow. On the other hand, long-run average stock returns are considerably lower than the returns 10

12 earned during the time period. Thus, it will be interesting to examine the behavior of the tax benefit as returns revert to lower levels Empirical Analysis Table 4 compares the determinants of the tax benefit to the determinants of other operating cash flows. Typically, operating cash flows are thought of as generated by the core operations, which generally involves producing and delivering goods and providing services (FASB, FAS 95, paragraph 21). Accrual accounting is used to correct the timing problems associated with these cash flows. Consequently, operating cash flows show a negative association with current, lagged, and future accruals (e.g. Dechow, Kothari, Watts, 1998; Dechow and Dichev 2001). As suggested previously, however, the tax benefit is unlike other operating cash flows. It is linked to the exercise of employee stock options. Thus, there is no direct link between the level of current or past accruals, and the level of the tax benefit. Instead, the amount of the tax benefit is likely to be a function of employees risk aversion and liquidity needs, and the recent performance of the firm s stock. Operating cash flows excluding the tax benefit, on the other hand, exhibit a strong negative relation to current and past accruals (Dechow and Dichev 2001). Because these cash flows are generated by the core operations of the firm, movements in the firm s stock price should not directly affect them. 7 We begin our analysis by providing a correlation matrix. We examine the univariate correlations among the tax benefit, operating cash flows excluding the tax benefit, current and lagged accruals, and current and lagged stock returns. Panel A of Table 4 displays the results of the correlation analysis in a matrix, with Pearson product moment (Spearman rank order) correlations presented above (below) the diagonal. Our discussion 6 For example, Cisco issued their annual report for the year ended July 31, For Cisco, the tax benefit included in CFO decreased from $2.5 billion to $1.4 billion. Yet this time period included roughly three months where the stock traded at around $60 (relative to a current price of under $20 dollars). Thus, there was ample opportunity last fall for employees to exercise options at a high price, relative to past prices. 7 There is likely to be an association between cash from operations and current returns, simply because cash flows are a driver of value. It is more difficult to argue, however, that current stock returns drive operating cash flows (other than through the tax benefit). Nevertheless, the correlation only captures the association between these variables. 11

13 focuses on the Pearson correlations, but similar patterns are evident in the Spearman correlations. The results in Panel A show that the tax benefit is positively correlated with both current and lagged returns (ρ=0.21 and 0.22 respectively). The tax benefit exhibits a negative association with current accruals (ρ=-0.18), but no association with lagged accruals. In contrast, other operating cash flows (CFO) exhibit strong negative correlations with both current and lagged accruals (ρ=-0.29 and respectively), a positive association with current returns (ρ=0.15), and no association with lagged returns. Therefore, unlike other operating cash flows, the tax benefit is associated with lagged stock returns. Conversely, operating cash flows are associated with lagged accruals, although the tax benefit shows no relation to this variable. Panel B presents partial correlations between the tax benefit and current and lagged accruals after controlling for the current and lagged returns, and partial correlations between cash from operations and current and lagged returns after controlling for current and lagged accruals. The results in the first line of panel B show that after controlling for current and lagged returns, there is no association between the tax benefit and either current or lagged accruals (ρ c =-0.03, p=0.63; ρ c =-0.02, p=0.75). This result is intuitive, and reflects the fact that the tax benefit is not included in net income, and hence there is no accrual associated with this cash flow. The results presented in Panel B show that cash from operations excluding the tax benefit are not associated with past returns after controlling for accruals (ρ c =0.04, p=0.41), although there still remains a positive relationship with contemporaneous cash flows (ρ c =0.20, p<0.01). Similar to the univariate analysis, the results of Panel B highlight the differences between the tax benefit and other operating cash flows. Our primary analysis investigates the impact of the tax benefit on stock returns. In general, discounted cash flow valuation theory implies that unexpected increases in operating cash flows, which are a component of free cash flows, increase firm value and, hence, should translate into positive returns (e.g. Dechow 1994). As argued in the 12

14 introduction, however, the tax benefit behaves differently from other operating cash flows. In particular, the tax benefit from employee stock options arises only when the market price exceeds the strike price of the options exercised. The larger the tax benefit, the greater the amount of the wealth transfer to the employees at the expense of other shareholders. Aboody (1996) and Aboody et al. (2001) show that estimates of the compensation expense for employee stock options tend to be negatively related to share price. Therefore, we expect that the wealth transfer or dilutive impact of the employee stock options will dominate the positive cash flow received from the tax benefit. Hence, we expect a negative relation between unexpected realizations of the tax benefit and contemporaneous stock returns. We begin the analysis by conducting a regression of contemporaneous returns measured over the firm s fiscal year, on the change in earnings, allowing for different coefficients on the cash and accrual components of income, the change in the tax benefit, market beta, and the book to market ratio. The change in the tax benefit is intended to proxy for the unexpected component of this item, which implies that it behaves as a random walk. An alternative way to model the tax benefit would be to use the level of the tax benefit, which would imply a zero expectation on average. Tests using the level of the tax benefit produce similar results to the tests reported using the change in the tax benefit. Therefore, we estimate the following model: Ret i,t = α +β 1 NI i,t + β 2 CFO i,t +β 3 TBNSO i,t + β 4 Beta + β 5 Book_Mkt + ε i,t (1) Where NI i,t = change in net income scaled by beginning total assets; CFO i,t = change in operating cash flow excluding the tax benefit scaled by beginning total assets; TBNSO i,t = change in the tax benefit from employee stock options scaled by beginning total assets; Beta i,t = coefficient from firm specific regression of returns on a value weighted market index, for the prior 36 months, Book_Mkt equals the book value of equity deflated by the market value of equity at the beginning of the year. Alternatively, we deflate the independent variables by beginning of the period market value of equity 13

15 (e.g. Christie 1987) with similar results, although the tabular results report only the results of the asset-deflated regressions. 8 Table 5 displays the results of the ordinary least squares estimation of equation (1). Our results show that changes in both the cash and accrual components are related to contemporaneous returns, although the cash component has a larger coefficient than the accrual component. This is consistent with the research showing that both accruals and cash flows have incremental information content (e.g. Rayburn 1986, Wilson 1987) and research showing a significantly larger coefficient on the cash component of earnings (e.g. Subramanyam, 1996; Collins and Hribar 2001). The coefficient on the change in the tax benefit from employee stock options is also significantly positive (β 3 =2.03, p<.01). On the surface, this suggests that the market positively prices changes in the tax benefit, and that the cash flow implications dominate the wealth transfer and dilutive implications of the underlying options. The primary issue with the analysis in Table 5, however, is that it ignores the endogeneity between the tax benefit and contemporaneous returns. In particular, we know that the exercise of options depends on a number of factors, including liquidity needs, risk aversion of employees, and the past performance of the stock (see, e.g., Huddart and Lang 1996). Indeed, we have already demonstrated in Table 4 that the tax benefit is a function of current and past stock returns. Because stock returns are a determinant of the tax benefit, and because we want to estimate the impact of the tax benefit on stock returns, it is more appropriate to simultaneously model the relationship between the tax benefit and stock returns. The analysis in Table 5 ignores the endogeneity of the tax benefit and, hence, parameters estimated using ordinary least squares are biased and inconsistent, and can lead to potentially erroneous inferences (Greene, 1993; D Souza, 1998). 8 Because of the joint estimation procedure we employ, it is not clear that beginning of the period market value of equity is unequivocally the best deflator. In particular, the second equation in our simultaneous equation system models the tax benefit as the dependent variable, and the tax benefit is arguably a function of the beginning of the period market price. 14

16 To examine the potential endogeneity, we begin by conducting a variant of the Hausman test for endogeneity known as the omitted variables approach (D Souza 1998). This version of the test entails expanding the right hand side of equation (1) to include both the predicted values from a regression of TBNSO on all of the exogenous variables (i.e. the instrumented variable) and actual values of the endogenous variable ( TBNSO). The test is conducted by examining the significance of the instrumented variable, where a significant t-statistic indicates that the null of no endogeneity is rejected. Performing this test, we attain a t-statistic of 2.93 on the instrumented variable, suggesting that endogeneity is indeed a concern in our analysis. In order to jointly estimate the system, we identify a system of equations that explicitly models returns as a function of the tax benefit and other exogenous variables, and the tax benefit as a function of returns and other exogenous variables. To allow for joint estimation, we need to identify at least one exogenous variable that is uniquely related to each endogenous variable. The exogenous variables that we use as instruments are partially motivated by the analysis of the previous section. In particular, we use lagged returns as an instrument for the tax benefit. Lagged returns are related to the current level of the tax benefit because they increase the likelihood of options being exercised, but are not related to current returns. 9 We use a proxy for current taxable income as an additional exogenous variable because it captures the firm s ability to receive the tax benefit. We estimate the level of taxable income by grossing-up the current portion of income tax expense by a factor of 1/ We use changes in net income and changes in cash from operations as exogenous variables for current returns. These variables are known to impact returns, but since they are driven by the core operations of the firm, they are not necessarily related to 9 Beaver et al. (1997) use lagged returns as an instrument when simultaneously estimating the earningsreturns relation. 10 Without taxable income, the firm can still debit deferred tax assets. This transaction, however, will not impact the current period operating cash flows since the tax benefit is not realized. As an alternative, we use the level of net income, which produces similar results. 15

17 the tax benefit from stock option exercises. Beta is included in both regressions because as a measure of risk it is a determinant of raw returns, and because of its link to stock price volatility, it will impact the number of options exercised. Similarly, book-to-market is included in both regressions because it is posited as a risk factor and also is likely to be associated with cross-sectional differences in employee stock-option usage. Therefore, we jointly estimate the following system of equations: Ret i,t = α +β 1 NI i,t + β 2 CFO i,t +β 3 TBNSO i,t + β 4 Beta + β 5 Bookmkt + ε i, TBNSO i,t = γ +δ 1 Ret i,t + δ 2 Ret i,t-1 +δ 3 TI i,t + δ 4 Beta + δ 5 Bookmkt + η i,t (2a) (2b) Where the variables in equation (2a) are as defined above, Ret i,t-1 equals lagged annual buy and hold return, and TI i,t equals or estimate of the firm s current taxable income. We use a two-stage least squares estimation approach, as used in Welker (1995), Beaver et al. (1997) and D Souza (1998). Two-stage least squares has typically been utilized in the accounting literature because of the sensitivity of more complex estimation methods to specification errors (Welker, 1995). Incorrectly specified equations can also lead to an erroneous rejection of the null hypothesis of no endogeneity (D Souza, 1998). To test for this issue, we use a statistic proposed by Hausman (1983) to examine if any exogenous variables have been incorrectly omitted from the equation we are estimating. This test entails regressing the residuals from the equation on the full set of exogenous variables. A χ 2 statistic is then computed as the product of the R 2 and the sample size (N), with degrees of freedom equal to the number of over-identifying restrictions (equal to 1 for both equations). Rejection of the null hypothesis that this statistic equals zero implies that exogenous variables have been incorrectly omitted, and that a simultaneous estimation procedure is inappropriate even if the null hypothesis of no endogeneity is rejected (D Souza 1998). A calculation of the test for over-identifying restrictions produces a test statistic of χ 2 = 0.02, which has an associated p-value of Hence, it does not appear as though any of the exogenous variables have been incorrectly omitted from equation (2a). 16

18 We present the results of simultaneously estimating equations (2a) and (2b) in Table 6. Our focus is on the results for equation (2a), since we are interested in the market s reaction to changes in the tax benefit. In contrast to the ordinary least squares results reported in Table 5, the coefficient on the TBNSO is now significantly negative (β 3 = -5.17, t-stat = -2.01). Thus, after controlling for the fact that the tax benefit is a function of current stock returns, we find that investors negatively price the cash flow associated with the tax benefit. The sign on earnings and cash flows both remain significantly positive, implying that changes in both cash and accrual components of earnings are positively related to current returns, as demonstrated in previous research. The coefficient on beta becomes significantly positive, as opposed to being insignificant in the ordinary least squares estimation. The estimation of equation (2b) shows that all coefficients are significant and positive as expected. Current and lagged returns are positively related to the changes in the tax benefit, as well as the level of net income (a proxy for taxable income) and market beta (a proxy for volatility). The results in Table 6 suggest that unlike other components of operating cash flows, the tax benefit from employee stock options appears to be negatively related to current returns after controlling for the endogeneity of returns and the tax benefit. Several points related to this result are worth noting. First, the significant negative coefficient suggests that the wealth transfer effect of the tax benefit dominates the positive cash flow impact from the realized tax savings. This is consistent with results in Aboody (1996) and Aboody et al. (2001) who document a negative relation between option based compensation expense and market prices. Second, our results show that there still exists a significant share price reaction in the year of exercise. Thus, the uncertainty with respect to the realized cost of employee stock options causes a significant price reaction as investors update their expectation of the cost of the employee stock options to the firm. This might be due to difficulties with ex-ante predicting the number of early exercises or unexpected shifts in the underlying inputs to an option-pricing model. Third, our results underscore the significance of using a simultaneous equations approach to measure the impact of the tax benefit on stock returns. Since the two variables are endogenously 17

19 determined, ordinary least squares estimation produced biased and inconsistent parameter estimates. In our case, the endogeneity actually caused the sign on the tax benefit in the ordinary least squares estimation (i.e. significantly positive) to be significant and in the opposite direction of the sign on the tax benefit in the jointly estimated model (i.e. significantly negative). 5. Conclusion This paper examined the empirical properties of the tax benefit from employee stock options. We analyze the tax benefit for a sample of Nasdaq 100 and S&P 100 firms from For each firm, we collect data on the amount of the tax benefit from the exercise of non-qualified employee stock options. Our main findings are as follows. First, the tax benefit is a large and growing component of cash from operations. For the Nasdaq 100 firms, the mean tax benefit was over 45% of reported cash from operations in fiscal Thus, the inclusion of this item in the operating section has the ability to substantially skew reported cash flow. Second, the tax benefit shows no association with current or past accruals, and instead is driven by factors such as the firms past stock returns. As such, it behaves very differently than other cash from operations, and should be considered separately when forecasting free cash flows for valuation purposes. Finally, we show that the market negatively prices the tax benefit from employee stock options. Thus, the dilution and wealth transfer effects appear to dominate the positive cash flow effect of the realized tax savings. Additionally, our analysis shows that ex-post information provided in the year of exercise is incrementally informative to investors. This is likely due to difficulties with ex-ante estimating parameters such as the amount and timing of early exercise, and changes in the underlying option value parameters. Our analysis is limited by data availability and the relatively recent increase in importance of this item. The sample we choose includes some of the largest publicly traded firms and, thus, our results may not generalize to the universe of firms. Additionally, because our time frame encompasses a relatively bull market, we are unable 18

20 to generalize the findings to other time periods. Going forward, it will be interesting to examine the behavior of the tax benefit as the market conditions change and, in particular, in periods of negative returns (e.g. fiscal 2001). Our findings underscore the importance of explicitly considering the tax benefit component of cash from operations when analyzing a firm s cash flow. Because of the variable nature of tax benefit from stock options and its association with a wealth transfer to employees, a large shock to this component of operating cash flow has different implications than a large shock to other components of operating cash flows. From a methodological standpoint, our results demonstrate the importance of explicitly considering the endogeneity between returns and the tax benefit when estimating the relationship between these variables. 19

21 Bibliography Aboody, D., 1996, Market Valuation of Employee Stock Options. Journal of Accounting and Economics 22(1-3): Aboody, D., M. Barth, and R. Kasznik, 2001, SFAS 123 Stock-based Compensation Expense and Equity Market Values, Working Paper Stanford University. Beaver, B., L. McAnally, and C. Stinson, The Information Content of Earnings and Prices: A Simultaneous Equations Approach, Journal of Accounting and Economics 23: Cohn, L. 1999, The Hidden Cost of Stock Options, Business Week, December 6, p.4. Collins, D. and P. Hribar, 2001, Errors in Estimating Accruals: Implications for Empirical Research, forthcoming Journal of Accounting Research. Dechow, P., 1994, Accounting Earnings and Cash Flows as Measures of Firm Performance: The Role of Accounting Accruals, Journal of Accounting and Economics 18(1): Dechow, P. and I. Dichev, 2001, The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors, Working paper, University of Michigan. Dechow, P., S.P. Kothari, and R. Watts, The relation between earnings and cash flows, Journal of Accounting and Economics 25(2): D Souza, 1998, Rate Regulated Enterprises and Mandated Accounting Changes: The Case of Electric Utilities and Post-Retirement Benefits Other than Pensions, The Accounting Review 73(3): Emerging Issues Task Force, 2000, Issue Summary No. 1 related to Issue No , Prepared May 30, Emerging Issues Task Force, 2000, Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option, Issue No , Issued July 19, Epstein, G., 1999, Sure, Options Pay Represents Funny Money, But Its Earnings Impact is Less that Critics Claim, Barrons, Oct 6. Financial Accounting Standards Board (FASB), 2001, Original Pronouncements, John Wiley & Sons, New York, NY. Fox, J., 2001, The Amazing Stock Option Sleight of Hand, Fortune 143(13):

22 Greene, W., 1993, Econometric Analysis, 2 nd Ed., Prentice Hall, Englewood Cliffs, NJ. Hanlon, M. and T. Shevlin, 2001, Accounting for Tax Benefits of Employee Stock Options and Implications for Research, Working Paper University of Washington. Huddart, S. and M. Lang, Employee Stock Option Exercises: An Empirical Analysis, Journal of Accounting and Economics 21(1):5-43. Mehran, H. and J. Tracy, 2001, The Impact of Employee Stock Options on the Evolution of Compensation in the 1990s, forthcoming, Economic Policy Review. Rayburn, J., 1986, The Association of Operating Cash Flow and Accruals with Security Returns, Journal of Accounting Research (Supp): Scholes, M., M. Wolfson, M. Erickson, E. Maydew, T. Shevlin, 2000, Taxes and Business Strategy: A Planning Approach, Prentice Hall, Saddle River, NJ. Subramanyam, K., 1996, The pricing of discretionary accruals, Journal of Accounting and Economics 22(1-3): Weiss, P., 2000, Stock options can skew cash flow, The Motley Fool website, originally published on December 28, Welker, M., 1995, Disclosure Policy, Information Asymmetry and Liquidity in Equity Markets, Contemporary Accounting Research 11(2): Wilson, P., 1987, The Incremental Information Content of the Accrual and Funds components of Earnings after Controlling for Earnings, The Accounting Review, 62,

23 Table 1 Sample Descriptive Statistics This table displays descriptive statistics for our sample over the period The sample consists of firms listed on either the S&P100 or the Nasdaq 100, excluding firms in the Financial Services industry. All financial variables are measured at the end of the firm s fiscal year. Beta is the coefficient from firm specific regression of returns on a value weighted market index for the prior 36 months. Panel A: All Firms Mean Median Market Value of Equity ($mil) 35,532 11,739 Beta Market to Book ratio Total Assets ($mil) 10,164 3,928 Net Income ($mil) Cash From Operations ($mil) Panel B: S&P Firms Mean Median Market Value of Equity ($mil) 96,950 26,624 Beta Market to Book ratio Total Assets ($mil) 21,033 17,081 Net Income ($mil) Cash From Operations ($mil) Panel C: Nasdaq Firms Mean Median Market Value of Equity ($mil) 23,912 8,314 Beta Market to Book ratio Total Assets ($mil) 4,602 1,592 Net Income ($mil) Cash From Operations ($mil)

24 Table 2. Magnitude of the tax benefit from employee stock options from 1997 through This table displays the magnitude of the tax benefit from employee stock options for the period The sample consists of firms listed on either the S&P100 or the Nasdaq 100. The value of the tax benefit is taken from annual reports, as reported in either the statement of stockholders equity, the statement of cash flows, or the tax footnote. Panel A reports raw dollar amounts, Panel B reports these amounts as a percentage of total cash from operations (including the tax benefit), and Panel C reports the amount as a percentage of the book value of equity. Panel A: Magnitude of tax benefit (in millions) Mean Q1 Median Q All Years Panel B: Tax benefit as a percentage of cash from operations (positive cash flow firms only) Mean Q1 Median Q % 0.00% 2.24% 6.78% % 0.00% 2.41% 9.41% % 0.00% 3.75% 15.75% % 0.00% 6.33% 26.83% All Years 19.18% 0.00% 3.10% 15.06% Panel C: Tax benefit as a percentage of book value of equity Mean Q1 Median Q % 0.00% 0.94% 1.50% % 0.00% 0.35% 2.03% % 0.00% 0.65% 2.90% % 0.00% 0.99% 3.91% All Years 2.32% 0.00% 0.72% 2.90% 23

25 Table 3. Magnitude of the tax benefit from employee stock options by index membership, from 1997 through This table displays the magnitude of the tax benefit from employee stock options for the period , broken out by index membership. The left side of the table presents results for the Nasdaq 100 firms, and the right side presents the results for the S&P100 firms. Financial institutions are omitted from the sample, resulting in a total of 180 firms. The value of the tax benefit is taken from annual reports, as reported in either the statement of stockholders equity, the statement of cash flows, or the tax footnote. Panel A reports raw dollar amounts, Panel B reports these amounts as a percentage of total cash from operations (including the tax benefit), and Panel C reports the amount as a percentage of the book value of equity. NASDAQ 100 Firms S&P 100 Firms Panel A: Magnitude of tax benefit (in millions) Mean Q1 Median Q3 Mean Q1 Median Q All Years All Years Panel B: Tax benefit as a percentage of cash from operations (positive cash flow firms only) Mean Q1 Median Q3 Mean Q1 Median Q % 1.55% 3.24% 6.78% % 0.00% 0.52% 2.73% % 0.00% 4.97% 15.06% % 0.00% 0.48% 3.26% % 0.03% 11.61% 25.11% % 0.00% 1.14% 5.40% % 3.34% 18.54% 37.42% % 0.00% 1.52% 6.92% All Years 28.43% 0.29% 9.52% 25.95% All Years 9.20% 0.00% 1.16% 4.54% Panel C: Tax benefit as a percentage of book value of equity Mean Q1 Median Q3 Mean Q1 Median Q % 0.00% 0.94% 1.50% % 0.00% 0.18% 1.21% % 0.00% 0.89% 3.39% % 0.00% 0.15% 1.62% % 0.00% 1.76% 4.55% % 0.00% 0.29% 1.56% % 0.06% 2.49% 6.35% % 0.00% 0.42% 2.21% All Years 3.24% 0.00% 1.59% 4.23% All Years 1.44% 0.00% 0.29% 1.60% 24

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