Financial Reporting for Employee Stock Options: Liabilities or Equity?

Transcription

1 Financial Reporing for Employee Sock Opions: Liabiliies or Equiy? Mary E. Barh Sanford Universiy Leslie D. Hodder Indiana Universiy Sephen R. Subben The Universiy of Norh Carolina a Chapel Hill subben@unc.edu November 2012 We wish o hank Parick Hopkins, Michael Kirschenheier, Sephen Penman, Jim Wahlen, and workshop paricipans a Brigham Young Universiy, Chinese Universiy of Hong Kong, Florida Inernaional Universiy, Harvard Business School, Maasrich Universiy, Ohio Sae Universiy, Oklahoma Universiy, Singapore Managemen Universiy, Universiy of Texas a Ausin, Washingon Universiy in S. Louis, and he Wharon School of he Universiy of Pennsylvania for helpful discussions and commens. Leslie Hodder graefully acknowledges financial suppor from Erns and Young, LLC.

2 Financial Reporing for Employee Sock Opions: Liabiliies or Equiy? Absrac This sudy seeks o deermine wheher employee sock opions have characerisics of liabiliies or equiy. Consisen wih warran pricing heory, we find ha common equiy risk and expeced reurn are negaively associaed wih he exen o which a firm has ousanding employee sock opions, which is inconsisen wih he opions having characerisics of liabiliies. We also find ha (1) he associaion is posiive for firms ha reprice opions and less negaive for firms ha have opions wih longer erms o mauriy, which indicaes ha some employee sock opions have characerisics ha make hem more similar o deb; (2) leverage measured based on reaing opions as equiy has a sronger posiive relaion wih common equiy risk han leverage measured based on reaing opions as deb; and (3) he sensiiviy of employee sock opion value o changes in asse value mirrors ha of common equiy value and is opposie o ha of deb value. Also, we find ha, unlike liabiliies, employee sock opions have subsanially higher risk and expeced reurn han common equiy. Our findings are no consisen wih classifying employee sock opions as liabiliies for financial reporing; raher, he opions ac as a second ype of equiy.

3 Financial Reporing for Employee Sock Opions: Liabiliies or Equiy? I. INTRODUCTION This sudy seeks o deermine wheher employee sock opions have characerisics of liabiliies or equiy, which is an open research and financial reporing quesion. 1 In paricular, we seek o undersand he relaion beween employee sock opions and common equiy risk and expeced reurn. This is because finance heory predics ha liabiliies increase common equiy risk and expeced reurn, whereas coningen claims on he firm s asses can decrease hem. Thus, if he associaions beween employee sock opions and common equiy risk and reurn are posiive, we infer he opions have characerisics of liabiliies. If he associaions are negaive, we infer he opposie. Alhough some prior sudies invesigae he classificaion of employee sock opions and conclude ha hey should be classified as liabiliies, he sudies do no provide empirical evidence ha unequivocally informs he issue. In conras o hese sudies, we evaluae employee sock opions relaive o crieria from finance heory, which suggess ha he direcional associaion of a claim wih common equiy risk and reurn can be used o disinguish liabiliies from equiy. We find ha he exen o which a firm has ousanding employee sock opions is significanly negaively relaed o boh common equiy risk and expeced reurn, which is inconsisen wih classifying employee sock opions as liabiliies. Our sudy is relevan o he curren debae abou wha characerisics should disinguish liabiliies and equiy for financial reporing purposes. The Financial Accouning Sandards Board (FASB) and he Inernaional Accouning Sandards Board (IASB) have been unable o 1 For financial reporing purposes, claims on he firm s asses are classified as eiher liabiliies or equiy. We use he erm common equiy o refer o presenly ousanding common equiy shares o disinguish his ype of claim on he firm s asses from oher claims, such as hose relaed o employee sock opions or preferred sock, ha are also classified as equiy for financial reporing purposes. We use he erm liabiliy o encompass all ypes of claims on he firm s asses oher han hose classified as equiy for financial reporing. Claims commonly referred o as deb comprise only one se of claims ha are classified as liabiliies for financial reporing purposes.

4 develop a clear principle ha disinguishes liabiliies from equiy. The curren Concepual Framework defines equiy as he residual of asses minus liabiliies, where liabiliies are presen obligaions, he selemen of which requires a ransfer of he firm s asses. However, his definiion is subjec o criicism because deermining wheher a presen obligaion exiss is subjecive, and because he form of selemen is subjec o srucuring. The resul is ha economically similar claims are accouned for differenly under curren GAAP. The FASB and IASB currenly have a join projec o improve, complee, and converge he wo boards concepual frameworks, and hey have found i difficul o develop a new definiion of liabiliies or equiy ha avoids hese criicisms. Alhough here is no debae abou wheher common shares ousanding should be classified as equiy and sraigh deb should be classified as liabiliies, here is debae abou wheher oher ypes of claims agains he firm s asses should be classified as oher ypes of equiy or as liabiliies and, if so, wha characerisics of hose claims are relevan o deermining he classificaion. Our sudy implemens an approach ha helps o inform he debae. Some prior sudies and he FASB s Preliminary Views on how o accoun for financial insrumens wih characerisics of equiy advocae a basic ownership approach ha would classify as liabiliies all claims on he firm s asses oher han ousanding common sock, including preferred sock and coningen claims, unless hey are named as excepions o he approach. Alhough he basic ownership approach assumes common equiy is he mos residual claim on he firm s asses, he lack of a definiion of residual claim makes i difficul o deermine wheher common equiy is he mos residual claim for firms wih complex capial srucures. For hese reasons, here has been resisance o adoping he basic ownership approach. We inform his debae by developing crieria derived from finance heory ha can be 2

5 used o disinguish liabiliies from equiy for financial reporing purposes. Specifically, we show ha he relaion beween a claim on he firm s asses and he risk of and expeced reurn on exising common equiy for which here is no financial reporing classificaion debae can be used o idenify claims wih characerisics of liabiliies. Our focus is on one paricular claim employee sock opions. Alhough he FASB s Accouning Sandards Codificaion Topic 718 Compensaion Sock Compensaion and Inernaional Financial Reporing Sandard 2 Share-based Paymen (IASB 2004) currenly prescribe equiy classificaion for employee sock opions, his classificaion could change depending on how he boards decide o deermine liabiliy and equiy classificaion. For example, under he basic ownership approach, employee sock opions would be classified as liabiliies, unless he boards named opions as an excepion from such classificaion. We show ha employee sock opions do no have characerisics of liabiliies. In fac, we find ha he opions have a higher expeced reurn han common equiy, which suggess ha he opions are more residual han common equiy, which is conrary o he premise underlying he basic ownership approach. We base our predicions and ess on warran pricing heory. Alhough he value of employee sock opions is commonly esimaed using opion pricing models, employee sock opions are a ype of warran wih feaures ha differ from boh opions and radiional warrans. A key difference beween warrans and opions is he eniy responsible for heir selemen. Whereas warrans are claims agains and seled by he firm, opions on a firm s shares are claims agains oher eniies (i.e., he wriers of he opions). Because warrans are issued and seled by he firm, he issuance of warrans including employee sock opions should affec common equiy risk and expeced reurn. In paricular, heory predics ha issuing warrans 3

6 decreases he firm s common equiy risk and expeced reurn, which is consisen wih employee sock opions de-levering he firm s common equiy, no levering i as does deb. Alhough finance heory oulines he implicaions of warrans for common equiy risk and expeced reurn, empirical ess are largely absen from he lieraure. We fill his void by esing he relaions beween common equiy risk and expeced reurn and he exen o which he firm has employee sock opions ousanding. Such ess are necessary because he heory derives from models based on assumpions ha may no be descripively valid, paricularly for employee sock opions. For example, employees may be able o influence he firm o amend he opion conracs afer issuance, hereby resuling in a conrac ha does no mee he definiion of a warran. Opion repricing is an example because repricing negaes he fixed price feaure of he opion, hereby enabling he opion holder o avoid bearing he asse risk i oherwise would bear. This makes he opion more similar o deb. We firs es wheher common equiy risk is posiively or negaively associaed wih he exen o which a firm has employee opions ousanding. A posiive associaion indicaes ha employee sock opions have characerisics of liabiliies, and a negaive associaion indicaes hey do no. We use wo measures of common equiy risk: realized common equiy volailiy and common equiy volailiy implied by he prices of a firm s raded opions. Following prior research, our ess include conrols for leverage unassociaed wih employee sock opions, credi risk, firm size, earnings, change in earnings, and analys forecass of earnings growh. Because riskier firms migh issue more opions and opions can provide incenives for risk-aking, we also include conrols for a firm s propensiy o issue opions and for subsequen risky invesmen. Second, we es wheher he expeced reurn on common equiy is posiively or negaively associaed wih he exen o which a firm has employee opions ousanding. Again, a posiive 4

7 associaion indicaes ha employee sock opions have characerisics of liabiliies, and a negaive associaion indicaes hey do no. Our measure of expeced reurn is an esimae of expeced cos of capial based on he Fama-French and momenum facors. Following prior research, our expeced reurn ess include conrols for leverage unassociaed wih employee sock opions, firm size, equiy book-o-marke raio, bea, momenum, analys forecass of earnings growh, and dispersion in analys forecass. As prediced, using boh measures of risk we find ha common equiy risk is significanly negaively associaed wih he exen o which he firm has ousanding employee sock opions, which indicaes ha employee sock opions de-lever a firm s common equiy, raher han lever i. We also find ha his relaion varies cross-secionally wih he average remaining erm of he firm s opions. Specifically, we find ha he relaion beween employee sock opions and common equiy risk is significanly less negaive for firms wih opions ha have longer remaining erms, which indicaes ha opions wih longer erms o mauriy have characerisics more similar o deb han opions wih shorer remaining erms. However, he relaion beween longer-erm opions and equiy risk is significanly negaive, indicaing ha even longer-erm opions work o reduce he risk of common equiy. For firms ha reprice opions, he relaion beween opions and common equiy risk is posiive, which indicaes hese opions have characerisics consisen wih liabiliies. These findings reveal ha he erms of employee sock opions are imporan, and can negae he common equiy risk-reducing characerisics of he opions relaive o radiional warrans. We nex examine he relaions beween common equiy risk and leverage measured in wo hypoheical accouning regimes one reas employee sock opions as equiy and he oher reas he opions as deb. Consisen wih our oher findings, we find ha leverage based on 5

8 reaing opions as equiy has a significanly sronger posiive relaion wih our measures of common equiy risk han leverage based on reaing opions as deb. These findings indicae ha classifying employees opions as deb would undermine he represenaional faihfulness of financial reporing-based leverage wih respec o common equiy risk. We also provide evidence on he sensiiviy of he values of employee sock opions, deb, and common equiy o changes in he value of he firm s asses. Finance heory predics ha deb and equiy values respond differenly o changes in asse value deb value is concave in asse value and common equiy value is convex. We find ha employee sock opion value is convex in asse value, similar o common equiy value. In conras bu consisen wih heory, we find ha liabiliy value is concave in asse value. These findings confirm ha employee sock opions share he risk and reurn characerisics of common equiy, bu do no share hese characerisics of liabiliies. Finally, we use a warran pricing model o esimae he expeced reurn on employee sock opions and find ha he reurn averages approximaely 70% more han he expeced reurn on common equiy. These findings indicae ha employee sock opions are subsanially more risky han common equiy, which also is inconsisen wih he opions having characerisics of liabiliies. Taken ogeher, our findings sugges ha classifying employee sock opions as liabiliies would misrepresen heir economic relaion wih common equiy. The remainder of he paper proceeds as follows. Secion II discusses he background for our inquiry and relaed research, and Secion III oulines he research design. Secion IV describes he daa and presens he findings relaing o common equiy risk and expeced reurn. Secion V presens evidence on how he values of deb, employee sock opions, and common equiy respond o changes in asse value, and esimaes of he expeced reurn on employee sock opions. Secion VI summarizes and concludes. 6

9 II. BACKGROUND AND RELATED RESEARCH Capial srucure effecs of employee sock opions Alhough he value of employee sock opions is commonly esimaed using opion pricing models, employee sock opions are warrans ha firms issue o employees as compensaion for services. Warrans are call opions on he firm s asses, no on is common equiy as specified in opion pricing models. Alhough opions and warrans have a fixed srike price and mauriy, warrans are seled on exercise when he warran holder conveys he srike price o he firm and he firm issues addiional shares of sock o he warran holder. Thus, warran exercise increases he firm s cash and, because warran holders only exercise warrans when hey are in he money, dilues common equiy. In conras, opions are wrien and exercised ouside of he firm. Thus, opion exercise does no affec he firm s asses, liabiliies, or equiy. In addiion, whereas opions can be raded, employees canno sell or oherwise ransfer employee sock opions. Each of hese differences can cause opion values and employee sock opion, i.e., warran, values o diverge. 2 Employee sock opions also have implicaions for he firm s capial srucure. Tha he exercise of employee sock opions modifies he firm s capial srucure is obvious. Opion exercise causes he firm o issue new shares of common sock and o receive he srike price in cash, hereby increasing boh he number of common shares ousanding and he firm s asses. Less obvious are he capial srucure modificaions ha occur when he firm issues he opions. Finance heory shows ha issuing warrans increases he expeced value of he firm s asses and decreases he expeced risk of and reurn on is common equiy (e.g., Daves and Ehrhard 2007). This occurs for hree reasons. Firs, employees pay for he opions wih heir services, leaving 2 Li and Wong (2005) esimaes ha he value of employee sock opions is oversaed by 6% when opion pricing models are used. Our esimaes of employee sock opion value in secion V are consisen wih his oversaemen (i.e., 5% of common equiy value compared o 4%). 7

10 addiional cash in he firm ha can be used for oher purposes. 3 Second, he expeced opion exercise price is anicipaed by he firm and is claimans from he opion issue dae. Therefore, he expeced value of asses increases wih he number of employee sock opions issued, and he opions are an addiional, poenially diluive claim agains his larger expeced asse base. Third, he issuance of employee sock opions decreases he expeced risk of and expeced reurn on common equiy. A decrease in common equiy risk and expeced reurn is consisen wih he opions having a de-levering effec on common equiy. This is wha would occur if he firm sells some of is risky asses a curren value and invess he proceeds in a riskless bond. When he firm receives he bond proceeds a mauriy, i will purchase risky asses a heir hen curren value. In his way, equiy holders are insulaed from asse risk beween he opions issue dae and exercise dae. Because our ineres is in deermining wheher employee sock opions have characerisics of liabiliies, our ess focus on his capial srucure effec. In paricular, if employee sock opions are associaed wih lower common equiy risk and expeced reurn, hen we infer ha he opions do no have characerisics of liabiliies. Liabiliies and equiy in financial reporing There is a lack of consensus as o how o draw a line beween liabiliies and equiy for financial reporing purposes, and which ype of claim is embodied in employee sock opions. The disincion beween liabiliies and equiy is crucial for he curren financial reporing model. Firs, idenifying liabiliies is imporan for calculaing leverage and, hus, assessing financial risk. Second, disinguishing liabiliies and equiy direcly affecs ne income afer iniial recogniion, changes in he recognized amouns of liabiliies are recognized in ne income bu 3 Opion compensaion procures labor resources provided over he vesing service period, which is he basis for he FASB s decision o require gran-dae opion values o be recognized as an expense over ha period. In addiion, opions affec he incenives of employees. Even hough we focus on he direc capial srucure effecs of opions raher han on he incenive effecs, our ess include conrols for possible risk-aking incenive effecs. 8

11 corresponding changes in equiy are no. 4 For example, if employee sock opions were classified as liabiliies, hen changes in he opions value are candidaes for expense recogniion. If he opions were classified as equiy, he changes in value are no. Wihou a clear classificaion disincion, earnings is ill-defined. The lack of consensus abou characerisics ha disinguish liabiliies and equiy is refleced in curren accouning sandards relaing o financial insrumens, which include over 60 pieces of lieraure ha have been called inconsisen (and) difficul o undersand and apply (FASB 2007, iii). The FASB s curren Concepual Framework defines liabiliies as probable fuure sacrifices of he firm s asses arising from a presen obligaion (FASB 1985, para. 35). This definiion ress primarily on wo facors: he exisence of a presen obligaion and he requiremen o ransfer he firm s asses in selemen. However, his definiion of liabiliies is subjec o criicism because deermining wheher a presen obligaion exiss is subjecive, and because he form of selemen is subjec o srucuring. The FASB and IASB currenly have a join projec o improve he boards concepual framework. The elemens phase of he projec is focused on improving he definiions of financial saemen elemens, a key objecive of which is o develop a definiion of liabiliies or equiy ha is no subjec o he same criicism as he exising definiion. However, o dae he boards have been unsuccessful in doing so. In a move oward developing hese new elemens definiions, he FASB issued Preliminary Views: Financial Insrumens wih Characerisics of Equiy ( Preliminary Views 4 Changes in he recognized amouns of liabiliies ha affec ne income include, e.g., ineres expense, amorizaion of deb issuance premium or discoun, fair value changes, and liabiliy selemen or cancellaion a amouns differen from recognized amouns. Corresponding equiy iems do no affec ne income. Wih respec o employee sock opions, much of he debae has cenered on he quesion of wheher he gran dae value of he opions should be used as he measure of he services rendered by employees in exchange for he opions and, hus, recognized as compensaion expense (see, e.g., Aboody, Barh, and Kasznik, 2004). Our sudy provides no evidence on his quesion, which relaes o he debi side of he ransacion. Insead, we focus on he effec of he issuance of he opions for he firm s capial srucure, i.e., he credi side of he ransacion. Specifically we address wheher employee sock opions embody claims agains he firm s asses ha have characerisics of liabiliies or of equiy. 9

12 FASB 2007) oulining is proposal for a basic ownership approach o disinguishing liabiliies and equiy. The Preliminary Views explains ha disinguishing liabiliies from equiy by applying he curren definiion of liabiliies is subjecive, paricularly o complex insrumens wih coningen selemen oucomes. For example, under curren requiremens, a wrien call opion is classified as a liabiliy if i mus be seled wih cash, bu is classified as equiy if i can be seled wih shares. In conras o curren Generally Acceped Accouning Principles (GAAP), he basic ownership approach would classify as equiy only common sock, i.e., here would be only one ype of equiy. As a resul, preferred sock, opions, and oher coningen claims would be classified as liabiliies under he FASB s proposed basic ownership approach, raher han as differen ypes of equiy. The basic ownership approach arguably is less subjecive han he curren definiion of liabiliies because i obviaes he need (1) o idenify he characerisics of liabiliies and (2) o deermine wheher paricular insrumens have such characerisics. Under he basic ownership approach, liabiliies comprise any claim ha is no he assumed basic ownership ineres, irrespecive of wheher he claim embodies a presen obligaion. However, defining equiy as only basic ownership ineress means ha liabiliies would be he residual caegory for claims agains he firm s asses. This conrass wih he curren definiion of equiy as asses minus liabiliies, and could lead o a classificaion sysem ha fails o reflec characerisics of nonbasic ownership claims ha affec he risk of and expeced reurn on basic ownership ineress. Consisen wih hese concerns, criics of he basic ownership approach believe ha classifying as liabiliies boh presen obligaions and non-obligaing financial insrumens would resul in a heerogeneous class of liabiliies and an arificially narrow se of equiies ha will decrease he usefulness of he balance shee, boh for assessing a firm s solvency, and for valuing is residual 10

13 claims (FASAC, 2001, page 388). 5 These criics believe ha he decision-usefulness of liabiliy and equiy classificaion derives from defining and idenifying liabiliies, no from defining or idenifying he mos basic ownership ineres. The financial reporing classificaion scheme we use in his sudy differs from boh curren GAAP and he proposed basic ownership approach. In paricular, we consider he associaion of a claim wih common equiy risk and reurn o disinguish liabiliies from equiy, which could resul in marked deparures from curren GAAP. For example, alhough under curren GAAP share appreciaion righs ha are seled in cash are classified as liabiliies, i can be shown ha, under reasonable assumpions, he form of selemen (e.g., shares or cash) does no affec he claim s effec on he value or risk of common equiy, or is expeced reurn. 6 Thus, even cash-seled share appreciae righs would be classified as equiy if classificaion were based on a claim s associaion wih common equiy risk and reurn. Research on he liabiliy-equiy classificaion debae The need o idenify liabiliies is consisen wih he heoreical finance lieraure ha models risk of and expeced reurn on common equiy as a funcion of financial leverage (Hamada 1969; Rubinsein 1973). Robichek and Myers (1966), among ohers, shows ha leverage has a negaive effec on common equiy value when bankrupcy is possible, or when leverage affecs fuure invesmen and growh. These sudies concepualize liabiliies as unavoidable obligaions o surrender firm asses in paricular saes of he world, and sugges ha disinguishing obligaions from oher claims and classifying claims based on heir idenifiable 5 Consisen wih his view, Terando e al. (2007) presens evidence ha marke paricipans differenially value share pus based on heir solvency characerisics. 6 The primary assumpions are ha (i) he price of common equiy shares reflecs he expeced diluion (in he case of share-seled conracs) or cash oulay (in he case of cash-seled conracs) associaed wih selemen of he conrac, and (ii) he marke for common equiy shares is sufficienly liquid. 11

14 risk and reurn characerisics should be helpful o invesors for valuing common equiy and for assessing is risk and expeced reurn. Regarding employee sock opions in paricular, several sudies view he opions as more akin o liabiliies han o equiy (e.g., Clark 1993; Balsam 1994; Hull and Whie 2003; Kirschenheier e al. 2004; Maines e al. 2004; Ohlson and Penman 2005; Sacho and Oberholser 2005; Landsman e al. 2006). Some of hese sudies conend ha he curren financial reporing concepual framework requires opions o be classified as liabiliies because opions reflec claims of poenial, no exising owners (e.g., Clark 1993). Ohers conend ha (i) he issuance of opions creaes a condiional obligaion o issue common sock for less han is value in some poenial fuure saes of he world, (ii) hese condiional obligaions are sufficienly presen o mee he definiion of a liabiliy, and (iii) values esimaed using valuaion models are he mos appropriae measures of hese obligaions a any reporing dae. Using his line of reasoning, several sudies suppor using he FASB s basic ownership approach. This is largely because he sudies view he objecive of financial reporing as providing informaion o exising common shareholders and, hus, common equiy is he mos basic claim by assumpion (e.g., Kirschenheier e al. 2004; Ohlson and Penman 2005). Anoher raionale for classifying employee sock opions as liabiliies is ha opion exercise resuls in a windfall gain o opion holders ha he firm should recognize as an expense. 7 Supporing his raionale, Hull and Whie (2003) expresses he view ha proper accouning requires expense recogniion of changes in opion value subsequen o gran dae. Under he curren accouning model, his view would require opions o be classified as liabiliies 7 Exercise dae value of employee sock opions is frequenly acceped as he real cos of compensaion. For example, Core, Guay, and Larcker (2008) finds ha negaive press coverage abou poenially excessive execuive compensaion focuses more on he proceeds from opion exercises han on gran-dae values. 12

15 because changes in he amouns of liabiliies no equiy are recognized in ne income. 8 Alhough Hull and Whie (2003) express he belief ha liabiliy or equiy classificaion is irrelevan for employee sock opions, inferring liabiliy or equiy classificaion from desired effecs on ne income would be a new approach o financial saemen classificaion. Some sudies aemp o provide empirical evidence on wheher he relaion beween common equiy values and employee sock opion values is consisen wih liabiliy or equiy classificaion of he opions. In paricular, Li and Wong (2005) and Landsman e al. (2006) show ha employee sock opions mus be considered when using a residual income model o esimae he value of common equiy. This is because ne income is deermined before subracing he fracion of income ha accrues for he benefi of eiher employee sock opion holders or common equiy holders, i.e., ne income accrues for heir combined benefi. Thus, failure o accoun for he fracion of income accruing for he benefi of opion holders causes he residual income model o oversae he esimaed value of equiy. Li and Wong (2005) uses oal residual income o esimae he combined value of employee sock opions and common equiy and hen subracs he opion value esimaed from a warran pricing model o derive an esimae of common equiy value. Landsman e al. (2006) evaluaes he relaive explanaory power of alernaive proforma mehods of accouning for employee sock opions, and finds ha subracing opion value from oal residual income over he erm of he opions increases he cross-secional explanaory power of he residual income model for common equiy value. 9 Landsman e al. (2006) concludes ha employee sock opions should be classified as liabiliies and changes in 8 For example, preferred sock is classified as equiy. Preferred dividends are subraced from ne income in deermining income available o common equiy holders, bu no in deermining ne income. 9 Subracing esimaed opion value from oal residual income implicily assumes ha he esimaed opion value equals he expeced presen value of residual income accruing o opion holders. 13

16 opion value each period should be included in ne income. Similar o Kirschenheier e al. (2004), Landsman e al. (2006) infers liabiliy classificaion from he apparen need o accoun for he value of employee sock opions when valuing common equiy. However, as Aboody (2006) poins ou, he residual income model canno be used o assess he efficacy of alernaive accouning mehods because if he residual income model is applied correcly, one should always be able o recover he value of common equiy. 10 Thus, he sudies do no provide evidence ha resolves he liabiliies versus equiy classificaion issue for employee sock opions. Oher sudies address liabiliy-equiy classificaion for preferred sock and converible deb by invesigaing heir relaions wih common equiy risk and expeced reurn. Cheng e al. (2007) finds ha preferred sock is associaed wih higher cos of common equiy implied by he residual income model and ha inclusion of a conversion feaure in deb conracs reduces he cos of common equiy, bu no he cos of preferred sock. As a resul, Cheng e al. (2007) concludes ha he marke views preferred sock as a liabiliy. Cheng e al. (2011) conducs similar ess bu using bea, idiosyncraic risk, and oal common equiy volailiy as measures of common equiy risk and finds ha preferred sock and claims oher han deferred axes, i.e., oher liabiliies, shor-erm deb, long-erm deb, and capial leases, are associaed wih higher common equiy risk. Cheng e al. (2011) concludes ha preferred sock and he deb componens are viewed as deb by he equiy marke and ha deferred axes are more equiy-like. Carrizosa (2010) finds ha he componens of converible deb, i.e., sraigh deb and he conversion feaure, are differenially relaed o bea and credi defaul swap (CDS) reurns and concludes 10 As an illusraion, consider a firm wih common equiy and raded warrans. For he residual income model o explain he curren value of warrans, he value of common equiy mus be subraced from residual income. However, his does no imply ha common equiy should be classified as a liabiliy when a firm has raded warrans. Landsman e al. (2006) can be viewed as providing evidence on hypoheical valuaion errors ha would occur if invesors incorrecly incorporaed, in specified ways, available informaion in applying he residual income model. 14

17 ha equiy holders and CDS invesors view converible deb based on is probabiliy of selemen as cash or common equiy shares. We conribue o his lieraure by empirically invesigaing he relaion beween employee sock opions and common equiy risk and expeced reurn, wih predicions based on warran pricing heory, o provide insighs ino classifying he opions as liabiliies or equiy. We show ha he associaions beween employee sock opions and common equiy risk and expeced reurn are opposie o hose of deb, and ha leverage raios ha rea he opions as equiy have a sronger relaion wih common equiy risk han leverage raios ha rea he opions as deb. 11 We also find ha cerain characerisics, such as repricing and longer erms o mauriy, make some opions more deb-like. Relaion beween warrans and equiy risk and reurn Modigliani and Miller (1958) shows ha in he absence of axes and ransacion coss, even hough oal firm value is independen of leverage, a firm s common equiy risk increases when i issues deb, and he expeced reurn on common equiy reflecs a risk premium 11 Repored leverage during he life of he opions differs depending on how he opions are classified. However, afer he end of he opion s life, repored leverage is he same regardless of wheher opions are classified as equiy or as liabiliies wih changes in opion value recognized as an expense, and regardless of wheher he opion is exercised or expires ou of he money. Consider firs he case of opion exercise. If opions are classified as liabiliies wih changes in opion value afer gran dae recognized as an expense in addiion o he gran dae value, here is an increase in he liabiliy and a corresponding decrease in reained earnings. When opions are exercised, cash is received for he srike price, he liabiliy is exinguished, and here is an offseing increase o paid in capial. The ne effec on equiy is he amoun of he srike price; he decrease in reained earnings offses he increase in paid in capial. Likewise, if he opions are classified as equiy, gran dae opion value is recognized as an expense, which decreases reained earnings, wih a corresponding increase in paid in capial. When he opions are exercised, cash is received for he srike price and here is a corresponding increase o paid in capial. Again, he ne effec on equiy is he amoun of he srike price. Consider nex he case of opions ha erminae ou of he money. If opions are classified as liabiliies, he aggregae effec on reained earnings is zero and no srike price is received. Thus, he ne effec on equiy is zero. If opions are classified as equiy, neiher he expense relaed o he gran dae opion value nor he amoun recognized in paid in capial corresponding o ha expense is reversed. Thus, he ne effec on equiy is zero. The componens of equiy reained earnings versus paid in capial differ beween he wo classificaions, bu no oal equiy. The reamen of opions as equiy is analogous o he curren accouning reamen for warrans issued by he firm. Warran proceeds received increase paid in capial and his amoun is no reversed when he warrans erminae, even if hey are ou of he money. This is because warran proceeds are viewed as a capial conribuion, as are he employee services in he case of employee sock opions. 15

18 commensurae wih his increased risk. Exending he work of Modigliani and Miller (1958, 1963), Hamada (1972) empirically shows ha realized common equiy reurns are increasing in leverage. However, he heoreical effecs of coningen claims on common equiy risk and reurn are no as sraighforward as are he effecs of sraigh deb. Ingersoll (1977) models he value of converible deb as a combinaion of he values of sraigh deb and a warran wih an exercise price equal o he amoun of implied sraigh deb. One implicaion of Ingersoll s (1977) model is ha he ne effec of converible deb on common equiy risk is a produc of wo counervailing forces: common equiy risk increases wih he implied amoun of sraigh deb and decreases wih he implied amoun of he warran. 12 Galai and Schneller (1978) exends Ingersoll (1977) and develops a model for pricing warrans on levered common equiy ha predics he issuance of warrans decreases he firm s common equiy risk and expeced reurn. Consisen wih Modigliani and Miller s (1958) resul for deb, warran valuaion models assume ha issuing warrans does no change common equiy value (Ukhov 2004; Daves and Ehrhard 2007). Because warrans are seled by he firm receiving cash and issuing common sock, he issuance of warrans a heir curren value is equivalen o he coningen sale of a fracion of he firm a is curren value in exchange for a riskless receivable. The appendix presens a numerical example o illusrae he implicaions of his heoreical lieraure. Inuiively, common equiy risk decreases as warrans ousanding increase because by issuing warrans he firm effecively sells a porion of he upside asse reurn 12 The FASB has considered a fundamenal componens approach in which he conversion feaure of converible deb would be disaggregaed and accouned for as equiy (FASB 1990) and Inernaional Accouning Sandard 32 requires i (IASB 2001). Alhough our ess focus on employee sock opions, basing liabiliy and equiy classificaion for financial reporing on an insrumen s associaion wih common equiy risk and expeced reurn could be used for any insrumen represening a claim on he firm s asses. For example, i could be used for hybrid insrumens or heir componens if he FASB or IASB requires disaggregaing hybrid insrumens. 16

19 poenial for is curren value. 13 This ransfer runcaes boh ails of he reurn disribuion for common equiy, hereby reducing he variance of is reurn. As Figure 1 in he appendix shows, when here is no uncerainy, he issuance of warrans is idenical o a sock subscripion, and neiher he value of nor he expeced reurn on common equiy changes. However, as Figure 2 in he appendix shows, in he more realisic case of uncerainy, common equiy risk and expeced reurn boh decrease, and common equiy value is unchanged. 14 Tha is, he issuance of warrans de-levers common equiy wihou changing is value. Empirical esimaion of Galai and Schneller s (1978) model parameers requires knowledge of he value of he firm s asses and he variance of he asses reurn, boh of which are unobservable. Largely as a resul of he idenificaion problem posed by unobservable parameers, he empirical validiy of Galai and Schneller s (1978) pricing model remains an open quesion (e.g., Noreen and Wolfson 1981; Galai 1989). As a soluion o he idenificaion problem, Ukhov (2004) develops an algorihm using only observable inpus for pricing warrans on levered common equiy and for deermining he variance of he warrans reurn. The Ukhov (2004) algorihm can be solved numerically, and provides a mechanism for compuing he price and variance of each of class of claims for a firm wih a complex capial srucure. More recenly, Daves and Ehrhard (2007) shows how o compue he expeced reurn on various capial srucure componens using observable daa. 15 In Secion V, we use he Daves and Ehrhard (2007) mehodology o compue employee sock opion values and expeced reurns. 13 In he example, his value is $ The deducibiliy of employee sock opion inrinsic value for ax purposes can provide benefis relaive o oher ypes of financing ha poenially reduce he cos of financing wih opions. We leave o fuure research he analysis of he relaion beween employee sock opion ax benefis and he value of and expeced reurn on common equiy. 15 Daves and Erhard (2007) assumes firm value is he sum of he values of deb and quasi-equiy, i.e., levered common equiy and he opions, and ha he quasi-equiy follows a Gauss-Weiner process. These assumpions yield a sysem of equaions ha can be used o esimae he values and expeced reurns of he hree claims. 17

20 Despie he heoreical basis for expecing ha warrans de-lever common equiy, he associaion beween warrans and common equiy risk and expeced reurn have no been esablished empirically. The heoreical models are based on assumpions, which may no be descripively valid, paricularly for employee sock opions. For example, employee sock opions frequenly are issued o insiders who may be able o influence he firm o amend heir opion conracs afer issuance. Such implici conracual erms may creae conracs ha do no mee he definiion of a warran. Repricing he opions is an example of such an opion conrac amendmen because repricing negaes he fixed srike price feaure of a warran, hereby enabling he opion holder o avoid bearing he asse risk i oherwise would bear, which makes he opion more similar o deb. Also, he warran models assume markes are complee, and he inabiliy of employees o sell heir opions is a form of marke incompleeness wih unclear implicaions for he models predicions. Moreover, disribuional assumpions underlying he models predicions migh no be descripive (Galai 1989). Therefore, esing he predicions of he models is necessary if he heoreical effecs of warrans on common equiy are o be used as a basis for financial reporing classificaion. 16 Alhough our empirical ess focus on employee sock opions, he classificaion crieria we use can be applied o oher claims. Finance heory, paricularly Meron (1974), shows ha he values of all claims on a firm s asses vary wih asse values, even claims wih conracually fixed payoffs. The exen o which and how a claim s value changes wih asse value changes deermines how ha claim affecs he risk and expeced reurn of all oher claims. 17 As a resul, a 16 For example, empirical ess validaing he Black-Scholes (1973) opion pricing model indicae ha he model is generally descripive. However, marke prices deviae from hose prediced by he model in paricular circumsances. See Mayhew (1995) for discussion. 17 For example, Figure 2 demonsraes ha he combinaion of uncerain asse values and asymmeric payoffs affec he volailiy and expeced reurns of common equiy. In paricular, wihou opions, common equiy holders receive 100% of he asse value in all saes of he world. Wih opions, here are wo effecs. Firs, he firm s asse base is larger (e.g., $119 wihou considering he expeced value of he srike price versus $100), on which i earns a reurn. 18

21 claim can be ranked based on is effec on he risk and expeced reurn of any oher paricular claim claims ha increase he risk and expeced reurn of anoher claim would be ranked as senior o he oher claim and claims ha decrease hem would be ranked as junior. Because here is no conroversy abou classifying common equiy as equiy for financial reporing, we use common equiy as he benchmark claim for disinguishing liabiliies and equiy. Claims ha increase he risk of and expeced reurn on common equiy are classified as liabiliies, and claims ha decrease he risk of and expeced reurn on common equiy are classified as equiy. III. RESEARCH DESIGN Common equiy risk We firs es wheher common equiy risk is negaively associaed wih he exen of ousanding employee sock opions, as prediced by finance heory. To do so, we esimae equaion (1), using wo measures of equiy risk, RISK. RISK OPTIONS LEVERAGE CREDITRISK SIZE EARN (1) 6CHANGE _ EARN 7GROWTH 8PROPENSITY 9CHANGE _ RD Our firs measure of RISK is he annualized sandard deviaion of he logarihm of monhly common equiy reurns, EQUITYVOL. The second is common equiy volailiy implied by he prices of a firm s raded opions, IMPLIEDVOL. Specifically, IMPLIEDVOL is he average of he implied volailiies from he firm s call and pu opions wih he longes mauriy and srike Second, in he final good sae, common equiy holders receive only 72.05% of ha higher asse value ($238.94/$331.61) because he opion holders receive he remainder. This lower share is no made up for by he higher asse base because opion holders share in all of he firm s asses, no jus in heir iniial $9 invesmen and is reurn. In conras, in he bad sae, common equiy holders receive 100% of he (higher) asse value and opion holders receive nohing. In combinaion, he lower value o common equiy holders in he good sae and higher value in he bad sae dampen he volailiy of common equiy. Had he firm issued deb insead, asymmery for he deb and common equiy payoffs would be differen. In paricular, deb holders would receive relaively less in he good sae (because hey do no share as much in upside asse value) and relaively more in he bad sae (because hey receive heir payoff before he common equiy holders receive heirs in he bad saes). The asymmery of payoffs associaed wih deb, even wih a higher asse base, resuls in increasing volailiy of common equiy, no dampening i. 19

22 price closes o he firm s sock price. Because no all firms have raded opions, we esimae equaion (1) using IMPLIEDVOL as he measure of equiy risk based on a smaller sample. We esimae EQUITYVOL using reurns over year + 1, and IMPLIEDVOL a he end of year. We measure all oher variables in equaion (1), and equaions (2) and (3) below, a he end of year or during year, depending on he naure of he variable. Our primary ineres is in he coefficien on he exen o which he firm has ousanding employee opions, i.e., 1, he coefficien on OPTIONS. OPTIONS is he number of employee sock opions ousanding divided by he sum of common shares ousanding and employee sock opions ousanding. We predic a negaive coefficien on OPTIONS if employee opions decrease he risk of common equiy. 18 Alhough he finance lieraure has no converged on a single, widely acceped model for common equiy risk, we include in Equaion (1) several variables as conrols for facors known o be associaed wih common equiy risk, i.e., leverage, performance, size, and growh. As a conrol for he amoun of sraigh deb in he firm s capial srucure, we include he deb-o-oal asses raio unassociaed wih employee sock opions, i.e., LEVERAGE. To consruc LEVERAGE, we measure deb as he book value of curren plus long-erm deb and measure oal asses as he sum of he marke values of common equiy and employee sock opions and he book values of deb, preferred sock, and minoriy ineres. Consisen wih Modigliani and Miller (1958), we expec ha common equiy risk is posiively associaed wih leverage. Because leverage is only one componen of defaul risk, we also include CREDITRISK as a conrol for credi risk. CREDITRISK is he firm s fied bond raing esimaed from a bond raing 18 We base OPTIONS on he number of opions, raher han heir esimaed value, because opion values are a posiive funcion of common equiy volailiy. Thus, using opion values would induce a posiive relaion beween opion value and RISK in equaion (1), which would bias agains our finding he significan negaive relaion ha we predic. However, unabulaed findings based on esimaing equaion (1) using opion values o consruc OPTIONS reveal he same inferences as he abulaed findings. 20

23 regression (Barh, Beaver, and Landsman 1998; Barh, Hodder, and Subben 2008). 19 Specifically, we esimae he relaion beween a firm s credi raing and financial saemen variables, i.e., asses, reurn on asses, leverage, and indicaor variables for wheher a firm pays dividends, has subordinaed deb, and repors negaive earnings, for he subsample of firms wih credi raings. 20 We hen apply he esimaed coefficiens from his relaion o he financial saemens amouns of he sample firms o obain fied values for credi risk. We expec ha credi risk is posiively associaed wih equiy risk. Prior research finds a negaive relaion beween firm size and common equiy risk (Pasor and Veronesi 2003). Thus, we include in equaion (1) SIZE, which is he naural logarihm of he marke value of equiy, and expec i has a negaive associaion wih common equiy risk. Hanlon, Rajgopal, and Shevlin (2004) finds ha operaing performance is negaively associaed wih common equiy volailiy. Thus, we include in equaion (1) earnings, EARN, and change in earnings, CHANGE_EARN, as conrols for operaing performance. EARN is annual income before exraordinary iems divided by oal asses, and CHANGE_EARN is he change in EARN from year 1 o year. We expec EARN is negaively associaed wih common equiy risk. We do no predic he sign of he associaion for CHANGE_EARN; CHANGE_EARN may reflec operaing performance ha is negaively associaed wih common equiy risk or shor-erm growh ha is posiively associaed. Because higher long-erm growh ypically is associaed wih higher risk and can provide opporuniies for managers o profi from equiy-based compensaion, we include GROWTH, he las consensus long-erm earnings growh forecas, in equaion (1) as a conrol for growh. In 19 Our abulaed findings are based on esimaing he bond raing regression pooling observaions over ime. Esimaing he regression separaely by year does no aler our inferences. 20 During our sample period, recogniion of sock-based compensaion expense became mandaory. Thus, o miigae he poenial for confounded coefficien esimaes, we calculae reurn on asses using ne income before sock-based compensaion expense. 21

24 addiion, Core and Guay (2001) finds ha firms wih more growh opporuniies gran opions more frequenly, suggesing GROWTH is likely o be posiively correlaed wih OPTIONS. Thus, failure o include a conrol for growh could bias he coefficien on OPTIONS. We expec GROWTH is posiively associaed wih common equiy risk. Firms selec wheher o issue employee sock opions, and here is evidence ha firms wih greaer operaing risk and more growh opporuniies are more likely o issue opions. Alhough we include GROWTH as a conrol for firms propensiy o issue opions, and SIZE and CHANGE_EARN can reflec operaing risk, here could be oher facors associaed wih OPTIONS and RISK ha are no capured by hese variables. Thus, we include in equaion (1) PROPENSITY as a conrol for firms propensiy o issue opions. We measure PROPENSITY based on Core and Guay (2001). In paricular, we esimae year by year he relaion beween OPTIONS and he naural logarihm of he sum of marke value of equiy and book value of deb, he naural logarihm of he number of employees, equiy volailiy, he book-o-marke raio, research and developmen expense divided by oal asses, and indusry effecs. 21 PROPENSITY is he prediced value from his relaion. We expec a firm s propensiy o issue opions is posiively associaed wih common equiy risk. Finally, opions can provide incenives for managers o increase he risk of he firm s asses (DeFusco e al. 1990; Rajgopal and Shevlin 2002; Williams and Rao 2006). 22 As a conrol for subsequen risky invesmen, we include in equaion (1) CHANGE_RD, he year The relaion in Core and Guay (2001) also includes segmen informaion as measures of oal diversificaion and geographic diversificaion. Because requiring he use of segmen informaion dramaically reduces our sample size, we do no use segmen informaion when consrucing our propensiy measure. However, unabulaed analyses reveal ha a propensiy measure ha includes segmen informaion is 99% correlaed wih our propensiy measure. No surprisingly given his high correlaion, our inferences are unchanged when we esimae equaion (1) using he alernaive propensiy measure and he subsample of firms wih available segmen daa. 22 Lamber, Larcker, and Verrecchia (1991) shows analyically ha opions can, for paricular parameer values, decrease risk-aking incenives. Alhough he expeced value of opion payoffs increases wih asse volailiy, opions are risky asses, and risk-averse, undiversified execuives can become more risk-averse if opions are a large componen of compensaion (Carpener 2000). Thus, he associaion beween opions and risk-aking is siuaional. 22