Arnold Kling

Stock Options and Overstated Earnings

Arnold Kling, Great Questions of Economics
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Walter M. Cadette blames stock option accounting for recent corporate scandals.

corporate America appears to be overstating its earnings by at least 20 percent. About half of the exaggeration reflects the lack of any recorded expense for options; the other half, manipulated operating earnings.

...With an option, the potential for loss is quite small; if the share price falls below the option price, the option simply becomes worthless. But the potential for gain is huge. The asymmetry encourages executives to downplay risk, if not ignore it, in the quest for returns.

I actually think that there are a lot of incentives for executives to be risk averse, so that I do not think that the stock option asymmetry is quite as bad as Cadette makes it out to be. But not counting stock options as an expense leads to all sorts of abuses.

A stronger argument against the stock option accounting anomaly is contained in this paper by Bebchuk, Fried, and Walker. They point out that options which are indexed to overall stock market movements are (a) better tied to executive performance and (b) treated properly as an expense by accountants. What this suggests is that from the perspective of managers trying to gain at the expense of their shareholders, the absence of transparency in stock option accounting is a feature, not a bug, of the current system.

Discussion Question. Why don't investors sell shares in companies that use stock options heavily and buy shares in companies that use them less?

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