The Effect of Expensing Stock Options on Corporate Earnings (Manuscripts‪)‬

ABSTRACT The increase in stock option grants is becoming increasingly controversial as disclosures emerge that senior executives of companies such as Enron Corp. have abused the exercising of their stock options. Currently, the SEC does not require that compensation expenses be reported on the income statement for stock option plans, allowing stock options, unlike other forms of compensation, to not be considered a business expense, meaning that they are not deducted from earnings. This policy creates an accounting incentive to pay executives with stock option compensation, which potentially allows companies to over-value their reported earnings. To examine if current accounting standards encourage firms to issue stock options as a form of CEO compensation to over inflate earnings, we use repeated cross-sectional data from Standard & Poor's ExecuComp annual data set on 2,412 firms from 1992 to 2000 on the CEO of a firm. We find that the extent to which reported earnings are exaggerated increased during the 1990s. This is true for absolute dollar figures as well as relative to a firm's net earnings. We also determine the degree to which firm size plays into the effects. Results suggest that firms, on average, over-inflated reported earnings by 5.1 percent. However, earnings can be over-inflated by as much as 13.6 percent for small companies.