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