Options Today, Restatement Tomorrow?

A Mays B-School study suggests a link between lavish options for CEOs and accounting practices that pump up stock prices

The conventional wisdom about the 1990s market bubble is that executive stock options were largely to blame. Encouraged by the favorable accounting treatment accorded options, corporate boards handed them out like candy. But instead of providing an incentive to create long-term shareholder value, options encouraged CEOs to inflate earnings and stock prices just long enough to take the money and run, say critics.

As it turns out, the critics may have been right. Research by the Mays Business School at Texas A&M University shows executive stock options can be blamed for helping power the tsunami of accounting restatements in recent years.


  Accounting Professor Edward P. Swanson, along with PhD candidates Jap Efendi and Anup Srivastava, compared CEO pay at 100 companies that announced restatements in the 18 months ending June 30, 2002, with CEO pay at 100 similar-size outfits that didn't have restatements. What they discovered should give board compensation committees -- and investors the world over -- serious pause.

Swanson and his team found a direct correlation between large numbers of in-the-money stock options held by CEOs and an increased likelihood of an accounting restatement. Companies where CEOs had options equal to five times their annual salary were 14% more likely to have a restatement than similar-size concerns in the same industry where CEOs had little if any option wealth. Companies where CEO option holdings amounted to 52 times their annual salary were 70% more likely to restate their financials.

Nowhere was the link between large option holdings and accounting restatements more apparent than at some of the high-flying tech outfits of the 1990s. The researchers make no allegations against specific executives. But some of the biggest accounting messes happened at businesses where executives have accumulated huge option stockpiles and exercised large numbers of options, the research shows.


  At JDS Uniphase (JDSU ), for example, then-CEO Kevin Kalkhoven had accumulated $1.3 billion in option wealth -- nearly 3,300 times his salary -- by the time the company announced a $38.7 billion restatement of goodwill from mergers and acquisitions in April, 2001, sending shares into a tailspin from which the one-time highflier has yet to recover. At Computer Associates (CA ), then-CEO Charles Wang had more than $500 million in options to his name in February, 2002, when the first inklings of accounting problems began to surface. Two years later, CA announced a $2.2 billion revenue restatement for 2000 and 2001.

What's more, CEOs who announced restatements exercised significantly more options -- about $1.8 million more on average -- in the two years prior to the announcement than did CEOs at the non-restating companies in the same period. At the tech company Nvidia Corp. (NVDA ), for example, CEO Jen-Hsun Huang exercised more than $12 million in options in the two years prior to the company's February, 2002, announcement that it had launched an internal review of its 2000 and 2001 finances related to the recording of reserves and expenses.

The announcement sent the stock plunging. Two months later, the company announced a restatement that increased net income for 2000 and 2002 and decreased net income for 2001.

The researchers concluded that CEOs who had accumulated large option stockpiles may have been motivated to artificially inflate stock prices and then cash out quickly. "This paper provides evidence that CEOs behaved opportunistically in the aftermath of the 1990s market bubble in an effort to support an overvalued stock price," they wrote in an as-yet unpublished paper. "Our evidence indicates that the CEOs' primary motive was to maintain or increase the stock price to benefit from in-the-money stock options."


  Harsh words, but the researchers aren't alone in their assessment. According to the General Accounting Office, accounting restatements increased 178% as the bubble economy ground to a halt, from less than 1% of listed companies in 1997 to a staggering 2.5% in 2001. During the 5½ period studied by the GAO, nearly 10% of companies listed on the New York Stock Exchange, Nasdaq, and American Stock Exchange had at least one restatement.

The period coincided with the heyday of executive stock options. Throughout the 1990s, corporate boards -- from startups to technology behemoths to old-economy stalwarts -- showered executives with options. By the end of the decade, many executives had accumulated huge stockpiles that increased astronomically in value with every stock surge. With share prices on the rise, CEOs had plenty of opportunities to cash in their options for multimillion-dollar paydays.

It wasn't until the bust that it became apparent what had happened. Overly aggressive accounting, using such techniques as improperly recognized revenue, nonexistent assets, and failure to account properly for acquisitions, allowed CEOs to turn options into cash at will.


  No evidence suggests that every CEO who received stock options engaged in aggressive accounting. But this is the first academic research on the subject to suggest that granting stock options played a role in improper accounting activities.

Some research has suggested poor governance practices -- particularly a lack of independent directors with financial expertise -- and pressure from capital markets allowed accounting manipulations to flourish. But it hasn't implicated stock options as a possible motive.

The new research does that -- and with alarming specificity. With the Financial Accounting Standards Board mandating that option expensing begin in 2005, and with option awards already declining as a result, the new knowledge is less useful today than it would have been 10 years ago, when the madness began. But history has a way of repeating itself, and when CEOs once again begin baying for options many years from now, compensation committees would do well to keep Professor Swanson's numbers handy.

By Louis Lavelle in New York

Edited by Patricia O'Connell