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The Employee Ownership Update

Corey Rosen

April 2, 2003

(Corey Rosen)

IRS Attacks Another ESOP S Scam

In a briefing to the Profit Sharing Council of America, the IRS said that it is developing guidance to prohibit ESOP S corporation structures in which a management corporation is formed to siphon off most of the ESOP's benefits. Specifically, the IRS said it will address situations in which:

Studies Question Whether Options Expensing Will Affect Stock Prices

There are several empirical studies of the impact of options expensing. The most comprehensive appears to be "Employee Stock Options, Residual Income Valuation and Stock Price Reaction to SFAS Footnote Disclosures," by Haidan Li at the University of Iowa (ERN Labor Journals, December 19, 2002). The paper looks at the three-day periods surrounding both the announcement of 10-K filings and the three-day period surrounding earnings announcements (these are typically released some time before 10-K filings). The study included data from 1,500 S&P companies. Li found that the market does react negatively to "unexpected" stock options expenses in the period around 10-K filings, but there is "no significant association between unexpected stock option expense and unexpected stock returns around earnings announcements." What this means, he says, is that the market already does incorporate data from footnote disclosures, indicating that formal expensing would not add much new information. Because 10-K filings typically come some time after earnings announcements, however, the market responds on a delayed basis to the information. Li notes that quarterly disclosures of options expenses (now required) will help resolve this problem, although he also thinks options expensing would make sense. The findings make it clear, however, that expensing would change more the timing of market reactions to options expenses, not the magnitude.

Other academic studies report inconsistent evidence on whether expensing would have any impact on stock prices. In a 1998 working paper for Texas A&M University by Lynn Rees and David Stout titled "The Value-Relevance of Stock-Based Employee Compensation Disclosures," the authors actually find that "using both price and return models, we find a significant association between the disclosed compensation expense [in footnotes under FAS 123] using the fair value method and firm value that is in the opposite direction from other income statement expenses. This result implies that (1) the disclosed employee stock option expense is a value-relevant measure, and (2) the incentives derived from employee stock option plans provide value-increasing benefit to the firm." If the authors are correct, expensing could be a good things for share prices.

In a 2002 working paper at UCLA and Stanford titled "SFAS 123 Stock-Based Compensation Expense and Equity Market Values," Mary Barth, David Aboody, and Ron Kasznik, looked at over 500 small- and mid-cap companies. The authors found that options expenses are viewed by investors as an expense of the company and that they are negatively associated with share prices. However this relationship is not a simple one and depends on such factors as employee turnover (valuations go up when turnover is lower and more options are exercised) and long-term earnings expectations (companies with higher long-terms earnings expectations show less impact form options expenses). The authors conclude that share pricing and options expensing are not easily matched.

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