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Does Conservative Stock Option Accounting Lead to Aggressive Cash Flow Reporting?

In this paper, we examine how the revised accounting for employee stock options affects the properties of reported cash flows. Although most investors are aware of the new option accounting required by FAS 123(R), relatively little attention has been given to the revised accounting for the tax benefit included in this standard. Yet, the tax benefit firms receive from employee stock options has been among the largest contributors to reported cash from operations since the rise in use of options plans. For example, during 2004, the tax benefit from employee stock options comprised over 25 percent of the operating cash flows for firms in our sample.

In addition to requiring expense recognition of employee stock options, FAS 123(R) changes how firms report the tax benefit from employee stock options. The new standard splits the tax benefit into two parts, each reported in different sections of the statement of cash flows. The amount of the tax benefit that is attributed to the reduction in tax expense from option compensation recognized in prior periods is included in the operating section. The remainder reflects the tax savings from the value realized at exercise that exceeds the option value estimated at the grant date. This component, commonly labeled ‘Excess Tax Benefit,’ is now reported in the financing section of the statement of cash flows.

One interesting implication of this standard is that the more conservative the accounting for options at the grant date, the larger the expected tax benefit that will be included in future operating cash flows. Firms that use an option pricing model or inputs to the model that yield a higher compensation expense in the year of grant will have a greater proportion of future tax benefits classified in the operating section of the statement of cash flows.

In fact, any firm whose accrued compensation expense is greater than or equal to the value ultimately realized at exercise will have the entire amount of the tax benefit included in the operating section. If the tax benefit from exercise of stock options exhibits different characteristics from other operating cash flows, then a firm’s ‘good’ accounting at the grant date could result in poor cash-flow reporting at the exercise date.

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Does Conservative Stock Option Accounting Lead to Aggressive Cash Flow Reporting?