Executive compensation, Executive stock options, Equilibrium warrant pricing model, APB opinion No. 25

Returns on common stocks are examined in this article for possible reactions to FASB deliberations on inflation accounting, using a "price reversal" methodology that does not require ex ante specification of the direction or magnitude of the reactions, The analysis concentrates on three specific events associated with these deliberations: the report in January 1974 that compulsory inflation disclosures had been placed on the FASB agenda; the report in November 1975 that the FASB had decided not to issue a statement in 1975; and the report in January 1979 that the FASB had once again proposed that inflation disclosures be required. The results suggest that there was indeed a market reaction to these inflation accounting deliberations.

The Basu and N&S methodologies differ on three dimensions: choice of test statistic, method of computing significance levels, and method for sampling from among the possible observable reactions. In our opinion, neither methodology dominates the other, and we could easily envisage future researchers drawing from both approaches. To a large extent, the three basic differences between the methodologies involve independent choices, so that it is possible to choose from the best features of each methodology. For example, a researcher might decide to use correlations as the test statistic (N&S), compute significance levels relative to an empirical distribution (N&S), and test for a significant correlation between the abnormal returns for one "partitioning" event and the abnormal returns for each of the other possible events (Basu).

Until 1974, firms could choose, within GAAP, to capitalize or expense interest costs associated with capital expenditures. The predominant practice had been to treat interest as a period expense. However, in 1974, the Securities and Exchange Commission imposed a moratorium on further adoption of interest capitalization by non-regulated firms. This study empirically examines economic factors potentially influencing firms' decisions to expense or capitalize interest prior to the SEC moratorium. We hypothesize that the choice may be affected by (1) the existence of management compensation agreements tied to reported earnings, (2) debt covenant constraints, and (3) the political costs (for some firms) of reporting higher earnings. When compared to the control group, our findings are that (1) the frequency of explicit management compensation packages was not greater for the interest capitalization group, (2) firms with financial ratios closer to likely debt agreement constraints (on dividends, interest coverage, and leverage) tended to elect interest capitalization, and (3) other than the largest firms in the ‘politically sensitive’ petroleum refining industry, the larger firms were more likely to capitalize interest.