Abstract Canadian firms face a trade‐off between reporting higher accounting income and paying lower taxes that arises from their ability to cancel in‐the‐money executive stock options and making a substitute cash payment to the executive instead of issuing shares. Firms' trade‐off hypotheses are operationalized in a multilateral framework and empirically tested using insider‐trading data. The multilateral approach is designed to control for the incentive effects of alternative compensation schemes and to determine the cancellation payment that keeps the executive indifferent between receiving cash or shares. The results show that firms consider both taxes and financial reporting costs in determining their option cancellation behavior.

Abstract This study explores the effects of financial and tax reporting incentives on options granted to chief executive officers in Canada. Extant studies with a similar objective (Yermack 1995; Matsunaga 1995) explore predominantly nonqualified U.S. option grants that are deductible to the extent that the options are in the money at the time of exercise. In contrast, Canadian firms do not get a tax deduction for their stock option grants at any time. In both countries, no expense is recorded for financial reporting purposes. As a result, the financial reporting and tax reporting trade‐off is more pronounced in the Canadian setting of this study compared with the U.S. setting. We measure option granting behavior as the ratio of the Black‐Scholes value of stock option grants to the sum of cash compensation and the value of stock option grants. Using a sample of 806 firm‐year observations during the period 1993‐95, we find that observed option grants are significantly correlated with proxies for short‐run financial reporting incentives. We also find evidence that option granting behavior is correlated with proxies for tax incentives.