December 5, 2002
Stock options get bad rap, accounting professor says
As the country marks the first anniversary of Enron’s bankruptcy this week, UW Business School research is questioning the recent claim that stock option compensations benefit executives to the detriment of shareholders.
According to accounting professor Terry Shevlin, there is little evidence of widespread mistreatment of stock options by the country’s top corporate managers despite the widely publicized scandals earlier this year involving former officials at Enron, Global Crossing and Worldcom.
Rather, he says, a study of more than 1,000 corporations shows that for every dollar in stock options given to a company’s top managers, that firm’s earnings go up an average of $2.85 during the next five years.
“The ongoing sentiment is that stock options are at the root of all evil, that they induce management to focus on short-term earnings in order to inflate the stock price today so they can cash out their options and make lots of money tomorrow,” Shevlin said.
“But our research indicates that options still have much-needed incentive features,” he said. “Their intent to align managers’ incentives with shareholders’ in order to maximize the value of a firm is effective over the long term.”
The mostly unregulated practice of giving managers stock options to boost compensation remained popular with boards of directors until earlier this year when several executives were caught cashing out millions of dollars in salaries and bonuses from their overvalued firms. Since then, many in Congress have been lobbying to limit stock options given to corporate managers.
Even so, Shevlin contends that companies should be free to offer stock options as incentives. His working paper, presented this fall at the Journal of Accounting and Economics Conference in Boston, provides hard evidence that current executive stock option grants to the top five executives at the country’s top companies coincide with higher future earnings for the companies, he said.
While they didn’t specifically study Enron’s earnings, Shevlin and his co-authors, Michelle Hanlon, of the University of Michigan Business School and Shivaram Rajgopal of Fuqua School of Business at Duke University, did study the earnings of more than 1,000 firms drawn from the Standard & Poors 500 index, the Standard & Poors mid cap index and the S&P 600 small cap index from 1992 to 2000.
“We found that on average there was not widespread options abuse,” Shevlin said. “Instead, we found that they are mostly used the way they are intended to be used.”
Further, Shevlin said their findings demonstrate that there isn’t widespread “rent extraction: If there was, then the executives would be getting $1 worth of options and giving nothing back.”
While Shevlin agrees that some new accounting regulations may be in order since the Enron and Worldcom scandals, he warns against blindly limiting stock-option compensations. Instead he contends that the actions of some, no matter how severe, do not justify taking steps against all companies that use executive stock options as incentives.
“What’s important to distinguish here is that on average these bad things are not happening at all firms,” Shevlin said. “If you regulate to stop three firms, for example, then you put the other 997 at a disadvantage. So, we have to be careful that regulating doesn’t end up hurting the firms that use them wisely.”
Shevlin’s working paper was funded in part by the Accounting Development Fund, as well as the Deloitte and Touche Fellowship.
