Cancellation of executive stock options: tax and accounting income considerations

An issue of interest in positive accounting theory is the extent to which tax factors influence financial reporting strategies. For most organizations, financial reporting strategies cannot be planned in isolation from overall tax planning, since financial reporting costs and benefits often need to be weighed against tax costs and benefits. Specifically, financial reporting costs are economic costs of reporting lower accounting income. The tradeoff between reporting higher accounting income and paying lower income taxes has been researched in the areas of inventory and related accrual management (Hunt et al. [1993] and Dhaliwal et al. [1992]), income shifting over time in response to a known schedule of declining tax rates (Guenther [1994] and Scholes et al. [1992]), financial reporting strategies of banks (Chen and Daley [1994] and Heatty et al. [1992]), pension reversion decisions of firms (Clinch and Shibano [1992]) and executive compensation strategies Matsunaga et al. [1992]).

This study continues this strand of literature by identifying a tradeoff between accounting income and tax payable faced by Canadian public corporations in the area of executive stock options. The tradeoff arises from the firm's ability to cancel its executive stock options that would otherwise have been exercised by substituting a cash payment to the executive for the issue of shares. This tradeoff hypothesis is 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 option-holder indifferent between receiving cash and shares. This ensures that tax as well as nontax factors for all parties are considered.

A large component of the cost differences between exercise and cancellation strategies is driven by differences in tax liabilities. Calculating this difference in tax liability requires estimation of firms' marginal tax rates. This study estimates such rates by simulating taxable income, and applying non-capital losses according to the loss carryover provisions of the Canadian Income Tax Act.

The study tests the hypotheses that the choice of compensation plan largely depends on the firm's tax position and financial accounting-based covenants. The results show the tax-driven cash flow variable is not statistically significant in explaining firms' cancellation behaviour. However, firms' need for higher accounting income statistically explains some of their cancellation behaviour.