Knowledge that Transforms

This paper describes the exercise behavior of over 50,000 employees who hold longterm options on employer stock at eight corporations. Employees typically exercise options years before expiration, commonly sacrificing half of the Black-Scholes value. Exercise is strongly associated with recent stock price movements, the market-to-strike ratio, proximity to vesting dates, time to maturity, volatility, and the employee's level within the company. These findings have implications for compensation planners, the FASB as it develops a new accounting standard for options, and financial statement users and preparers who apply and interpret the new FASB standard.

Reinsurance transactions provide an immediate enhancement to insurers' earnings and equity. The study investigates the use of reinsurance for regulatory and tax purposes. Traditional and financial reinsurance are examined separately, since the latter does not transfer significant insurance risk to reinsurers, and is viewed by regulators primarily as a means for enhancing statutory and financial reports. Both a univariate analysis and a multiple regression analysis support the hypothesis that insurers enter into financial reinsurance transactions to reduce regulatory costs. The results do not support the hypothesis that insurers adjust their reinsurance level as a function of their marginal tax rates.

We investigate use of individual performance evaluation in CEOs' annual incentive plans. In contrast with relatively objective accounting and stock-price-based measures, individual performance evaluation may involve discretion and subjectivity, as well as nonfinancial and financial performance criteria. Based on agency theory, we predict that individual performance evaluation increases with the importance of growth opportunities relative to assets in place, length of product development and product life cycles, and noise in traditional financial measures. Using proprietary compensation data, we find evidence that individual performance evaluation increases with growth opportunities and product time horizon.

This paper examines the exercise of employee stock options (ESOs) by executive officers. We document a positive relation between the variance of ESO returns and the remaining life of the option at exercise, and show that the strength of the relation is reduced by the extent the firm hedges the returns on the ESO. We thus provide empirical evidence of a link between an ESO's expected term and its investment risk to the executive, and document that some firms provide a hedge against option risk.

Rendleman, Jones, and Latané (1987) and Bernard and Thomas (1990) hypothesize and report evidence that investors use a ‘naive’ seasonal random walk model, at least in part, for quarterly earnings. We show that the market acts as if it: (1) does not use a simple seasonal random walk model; (2) does exploit serial correlation at lags 1–4 in seasonally-differenced quarterly earnings; (3) does use the correct signs in exploiting serial correlation at each lag; but (4) underestimates the magnitude of serial correlation by approximately 50% on average. We discuss the consistency of alternative hypotheses with our evidence.

Using a sample of LIFO users, we examine the strengths and weaknesses of adopting a simultaneous equations approach to study managers' adjustments of interacting accounting measures that meet multiple objectives. We focus on the importance of considering differences in the costs and the effectiveness of adjusting accounting measures. In addition, we examine managers' objectives in subsequent years and how adjustments' reversals affect those objectives. Although generally consistent with earlier studies of LIFO inventory adjustments, our results indicate that modelling interacting accounting measures, such as other current accruals and depreciation, leads to differing conclusions about the role of taxes.

Short-window earnings response coefficients estimated from pooled time-series cross-sectional regressions are systematically smaller than corresponding averages of firm-specific coefficients estimated from time-series regressions. The cause is a negative relation between firm-specific earnings response coefficients and unexpected earnings variances. If the hypotheses of equality of firm-specific coefficients and equality of firm-specific unexpected earnings variances are rejected, firm-specific estimation should be used instead of pooled estimation. Using pooled estimation may lead to incorrect inferences about the magnitude of estimated coefficients and/or incorrect inferences about differences in coefficient behavior between groups of firms.

This paper examines if the stock market prices discretionary accruals. Evidence reveals that, on average, the market attaches value to discretionary accruals. This evidence is consistent with two alternative scenarios: (1) managerial discretion improves the ability of earnings to reflect economic value, and (2) discretionary accruals are opportunistic and value-irrelevant but priced by an inefficient market. Further evidence is consistent with the former explanation. There is evidence of pervasive income smoothing, which improves the persistence and predictability of reported earnings. There is also evidence that discretionary accruals predict future profitability and dividend changes. Despite several sensitivity checks, measurement error in the discretionary accruals proxy is an alternative explanation for the results.

We document that tax considerations influence whether and when a firm withdraws excess assets in its defined benefit pension plan through a reversion. Since a reversion impacts taxable income over many years and alternative methods of withdrawing excess assets exist, we argue that the economically relevant tax-based decision criterion is its ‘differential tax benefit’, defined as the difference between the discounted tax savings of reversion versus those of the best alternative withdrawal method. We develop a technique for directly estimating this decision criterion and document that differential tax benefits are strongly correlated with the reversion decision and its timing.