Stock Option Exercises and the Quality of Operating Cash Flows

Paul Hribar*a and D. Craig Nicholsb

a Tippie College of Business, University of Iowa, Iowa City, IA 52242

b Johnson School of Management, Cornell University, Ithaca, NY 14853

September 2008. Comments Welcome

Abstract. We examine the effect of accounting for stock options on the predictive ability and the pricing of operating cash flows. Using pre-123R data, we show that the large cash flows from tax benefits differ substantially from other operating cash flows when included in the operating section. Tax benefits from stock option exercises show no reliable association with future earnings, and the predictive ability of current period earnings components declines when the tax benefit is classified as an operating cash flow. We also find evidence that investors overprice the tax benefit when it is included in cash from operations, suggesting investors do not adequately differentiate if it from other operating cash flows. Our findings are robust to the inclusion of a variable capturing option exercises, suggesting that the misvaluation is due to the inflation of operating cash flows when tax benefits are included, not just the negative signal associated with large exercises. Overall, our analysis suggests that the tax benefit from employee stock options reduces the usefulness of operating cash flows in predicting future earnings, and that investors do not attend to the differential implications of this item even when disclosed as a separate line on the statement of cash flows. * Corresponding Author. Tel: (319) 335-1008. E-mail address: paul-hribar@uiowa.edu. We have received helpful comments from Dan Collins, Cristi Gleason, John Phillips, Sonja Rego, Richard Sloan, Connie Weaver, Ryan Wilson, and workshop participants at Barclay’s Global Investors, Texas A&M, and the 18th annual Conference on Financial Economics and Accounting. This paper was previously titled “Does conservative stock option accounting lead to aggressive cash flow reporting?”

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Stock Option Exercises and the Quality of Operating Cash Flows 1. Introduction

This paper examines the future earnings implications of cash flows due to the tax benefit

firms receive when employees exercise stock options, and whether the market correctly prices

these implications when this cash flow is included in the operating section. Our analysis is

motivated by three considerations. First, the appropriate treatment of the tax benefit on the

statement of cash flows has been a contentious issue. Because the tax benefit relates to taxes and

compensation, it is conceptually similar to other operating cash flows. However, the tax benefit

only arises when the firm issues equity, similar in nature to other financing cash flows. Thus,

documenting the properties of the tax benefit and its relation with future earnings should prove

helpful to standard-setters and users of financial statements.1 Second, the tax benefit is an

economically significant source of cash for many firms. Tax benefits make up approximately ten

percent of total cash from operations among firms reporting a tax benefit on their statement of

cash flows, and amount to 1.6% percent of total assets for the typical firm in our sample.

Third, FAS 123R (effective for periods ending after June 2006) is written such that more

conservative assumptions regarding the value of options at the grant date lead to more tax

benefits being classified as operating cash flows upon exercise.2 In fact, any firm whose accrued

stock option compensation expense is greater than or equal to the value ultimately realized by the

employee at exercise will include the entire amount of the tax benefit in the operating section. If

1 For example, EITF 00-15 requires classification of the tax benefit as an operating cash flow for periods ending before June 2006, but Mulford and Comiskey (2002) conjecture that the tax benefit is non-recurring and is fundamentally a financing cash flow. We provide direct evidence on the transitory nature of the tax benefit and its usefulness in predicting future earnings. 2 Conservatism is a response to uncertainty that understates assets, overstates liabilities, accelerates expenses/loss, and defers revenues/gains. Conservative accounting for stock option grants will therefore tend to produce larger measures of option compensation expense at the date of grant. Conservatism is generally viewed as a useful characteristic of accrual accounting (e.g., Watts 2003). See section 2 for a discussion of the new rules for reporting the tax benefit from employee stock options under FAS 123R.

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the tax benefit possesses little or no information about future earnings, then FAS123R could lead

to the curious situation where a firm’s ‘good’ accounting at the grant date reduces the usefulness

of reported operating cash flows at the exercise date.

We collect our data from the periods before FAS 123R, when all tax benefits were

included in cash from operations. FAS 123R not only requires expense recognition for employee

stock options, but it also reclassifies part of the tax benefit as a financing cash flow. Despite the

changes in the accounting for the tax benefit, our analysis using this data remains relevant for

two reasons. First, under FAS 123R, a significant portion of the tax benefit will continue to be

included in cash from operations. Only tax benefits in excess of the deferred tax asset that is

established over the vesting period will be placed in the financing section. Second, the reporting

standard (EITF 00-15) during our sample period represents a special case of the accounting

under FAS 123R. The entire tax benefit will be included in cash from operations under FAS

123R if the firm’s estimate of option value at grant exactly equals (or exceeds) the value realized

by the employee at the time of exercise. Thus, accounting for the tax benefit under EITF 00-15 is

equivalent to the accounting under FAS 123R in the hypothetical best-case scenario, where

managers have perfect foresight and exactly estimate the value of options on the grant date.

We show that the tax benefit is more transitory than other operating cash flows and that it

has virtually no implications for future earnings. This latter result is not obvious because option

exercises strongly correlate with contemporaneous price changes, which prior research shows to

have significant information content for future earnings (e.g., Beaver, Lambert, and Morse, 1980;

Beaver, Lambert, and Ryan, 1987). Finally, we document a statistically and economically

significant negative relation between the tax benefit and future abnormal returns, suggesting that

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the market fails to fully impound the differences between the tax benefit and other operating cash

flows for future earnings.

Our results contribute to several streams of literature. Sloan (1996) and several follow up

papers show that operating cash flows are, in general, underpriced. We contribute to this research

by showing that there are significant differences in the components of operating cash flows, and

we identify a large cash flow that is substantially less persistent than other accruals and cash

flows. As the magnitude of the tax benefit increases, the overall persistence of cash flows is

considerably reduced. We show that investors’ failure to adequately differentiate this from other

cash flows can lead to a significant overpricing of this component. One important feature of our

study is that, in our sample, the tax benefit is not included in earnings but is a part of cash from

operations. The fact that the tax benefit causes no differences in the reported earnings of firms

with high and low tax benefits suggests that placing an item in the operating section of the

statement of cash flows affects the pricing of stocks even without an earnings effect. This

provides an important piece of evidence that investors rely on the level of reported cash from

operations but may not adequately distinguish between the components contained therein.

We also contribute to the conservatism literature. That literature documents the existence

of, reasons for, and consequences of conservative accounting (see Guay and Verrecchia, 2006 for

a recent discussion). Research on conservative accounting generally concludes that conservatism

serves an important role in promoting the usefulness of financial reports. Although we do not

have enough data under the new standard to draw direct inferences for FAS 123R, we show that

the inclusion of the tax benefit in cash from operations creates a less useful measure for

predicting future earnings performance than when it is excluded. Because FAS123R will include

more tax benefit in the operating section when measurement of option value is conservative (i.e.

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firms record greater option expense), our evidence suggests that FAS123R leads to an unusual

situation where conservative accounting for stock option expense at the date of grant has the

potential to reduce the usefulness of financial reports in future periods.

Our results also add to the empirical tax literature. Prior studies examine the relation

between firm tax characteristics and overall earnings quality. We add to this research by

examining how the classification of a tax related item affects the quality of operating cash flows.

During our sample period, the tax benefit reflects the tax consequences of a permanent

difference. The effect of permanent differences on cash flow persistence has not been examined

in prior work. For example, Hanlon excludes permanent differences because they are difficult to

measure and because they are unrelated to earnings quality (Revsine et al., 2004). We identify an

economically important permanent difference that is measurable and provide evidence on its

implications for cash flow quality.

Going forward, the tax benefit reflects the tax consequences of a temporary difference

under 123R. Specifically, the tax benefit arises from a large positive book-tax difference. Hanlon

examines the effects of large positive book-tax differences on earnings persistence. Her results

suggest that large positive book-tax differences coincide with artificially high book income.

Thus, she concludes that large positive book-tax differences are useful indicators of earnings or

accrual quality and may indicate income-increasing earnings management. In contrast, large

positive book-tax differences resulting from option exercises result from particularly low taxable

income and have no direct implications for contemporaneous earnings management. Thus, our

results suggest an important difference in the interpretation of a large positive book-tax

difference depending on the activity giving rise to the difference. In addition, our results suggest

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excluding temporary differences resulting from option exercises could sharpen book-tax

differences as a financial statement analysis tool for assessing accrual quality.

Although Lev and Nissim (2004) examine the future growth and stock price

consequences of a composite tax characteristic that captures both temporary and permanent

differences, they specifically point out that their tax fundamental measure does not capture the

tax effects of employee stock option exercises (p. 1046). Moreover, their use of a composite tax

characteristic does not provide an understanding of individual tax-related components and

therefore does not shed light on the properties and potential implications for future performance

possessed by the tax benefit from employee stock options.

Our analysis suggests several avenues for future research. Our data covers the period

before implementation of FAS 123R. Although we identify how the details of the new standard

will likely interact with the empirical properties of the tax benefit to affect future operating cash

flow quality, future research could directly examine whether conservative option valuation

results in lower quality of future operating cash flows. Second, future research could examine

whether firms that understate options expense to meet earnings management objectives have

better operating cash flow quality in exercise years than similar firms that show no tendency to

manage options expense accruals. Finally, research could examine whether excluding temporary

differences due to option exercises enhance the usefulness of large positive book-tax differences

as an indication of earnings or accrual quality.

2. Background

2.1 Classification of the Tax Benefit in the Statement of Cash Flow

When employees exercise stock options granted under nonqualified stock option plans,

firms receive cash from two sources. First, firms receive the exercise price from the employee.

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This cash inflow is reported in the financing section of the statement of cash flows. Second,

firms receive a cash inflow (or the reduction of a cash outflow) from the government because

firms receive a deduction for the amount by which the market price exceeds the exercise price at

the time of exercise. The placement of the tax benefit in the statement of cash flows has been

controversial.

Prior to FAS 123R, the majority of companies did not recognize compensation expense

from the issuance of stock options in the income statement. Hanlon and Shevlin (2002) note that

only 2 of the Fortune 500 firms voluntarily expensed options in fiscal 2000, while Aboody,

Barth, and Kasznik (2004) found approximately 10% of the S&P1500 firms voluntarily expensed

options following the financial reporting scandals in 2002. Companies were prohibited from

recognizing this tax benefit as income if the associated compensation expense was not

recognized in income. This created a dilemma: the income tax benefit received by the company

did not impact tax expense for financial reporting purposes, but the cash impact of the tax

savings had to be accounted for in the statement of cash flows.

Initially, companies had no explicit guidance as to where the tax benefit should appear on

the statement of cash flows. Most companies classified the tax benefit as an operating cash flow

while a few classified it as a financing cash flow. Given the differences that arose across

companies in accounting for the same transaction, the Emerging Issues Task Force (EITF)

decided to examine the issue. The EITF considered three options: placement in the operating

section, placement in the financing section, or allowing firms to make their own determination of

the appropriate classification. Proponents of placing the tax benefit in the operating section

argued that this treatment was consistent with the treatment of income tax expense.

Additionally, for firms using the direct method, income taxes paid is included as a separate line

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in the operating section. Because the tax benefit reduces the cash outflow, it was argued that

taxes paid in the operating section would be greater than the amount actually paid if the tax

benefit was included in the financing section.

Proponents of placing the tax benefit in the financing section noted that stock options are

inexorably linked to the issuance of equity. Thus, they constitute a form of owner financing, and

cash flows related to stock options are rightly treated as financing cash flows. A comment letter

by Microsoft in support of treating the tax benefit as a financing cash flows cited FAS 123,

Paragraph 228 that states:

The amount of stock-based compensation that is deducted on the tax return may exceed the compensation cost recognized for financial reporting. This Statement requires that the tax benefits for deductions in excess of compensation cost be recognized as additional paid-in capital when they are initially recognized. The Board agrees with the conclusion of the Accounting Principles Board in Opinion 25 that the additional tax benefits are attributable to an equity transaction (p.1, emphasis in original) After deliberating the issue, the EITF reached a consensus, ruling that the tax benefit was

appropriately classified as an operating cash flow. Effective for fiscal periods ending after July

20, 2000, EITF 00-15 required companies to include the tax benefit triggered by the exercise of

non-qualified employee stock options as an operating cash flow. Moreover, EITF 00-15 required

explicit disclosure of a material tax benefit if it is not included as a separate line in either the

statement of cash flows or the statement of changes in stockholders’ equity.

Articles in the popular press expressed concern over the treatment of the tax benefit from

employee stock options as an operating cash flow (e.g. Weiss 2000, Fox 2001). For example,

Weiss (2000) cautioned investors to be wary of the impact of stock option exercises on cash from

operations, stating “[the tax benefit cannot] be counted on with any regularity and is dangerously

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linked to two things that management has no control over – stock price and the desire of

employees to convert their options into cash (p.3).”

The recognition of stock compensation expense under FAS 123R reopened the debate

regarding the classification of the tax benefit from employee stock options. Effective for fiscal

periods ending after June 15, 2006, FAS 123R requires firms to measure the cost of options

granted to employees and allocate that cost to expense on the income statement over the vesting

period of the options. Under 123R, firms record a reduction in tax expense associated with the

stock compensation costs recognized in the income statement. Because the tax savings are not

realized until exercise, the tax effect is recorded as a deferred tax asset on the balance sheet. At

exercise, the deferred tax asset associated with the previously recognized stock compensation

expense is eliminated. This reduction in the deferred tax asset is reported in the operating section

of the statement of cash flows.

If the grant date value of the options exactly equals the value realized at exercise (market

price minus strike price), the deferred tax asset for the previously recognized stock compensation

expense will exactly equal the tax benefit from employee stock options.3 In this case, the entire

tax benefit appears in the operating section under FAS 123R. However, if the tax benefit is

greater than the deferred tax asset (i.e., if the amount realized at exercise is greater than the value

of the options as estimated at the date of grant), the additional tax savings are labeled ‘Excess

Tax Benefit’ and are classified as a financing activity.4 The classification of any of the tax

benefit as an operating cash flow could reduce the usefulness of operating cash flows as an 3 Here we assume the simple case of profitable firms. If a firm has losses, the deferred tax asset is not reduced until the tax benefit is realized (i.e., when the firm has taxable income against which it can use the tax benefit). The accounting for the deferred tax asset is generally governed by FAS 109. See Hanlon and Shevlin (2002) for additional issues that arise when firms have tax losses and valuation allowances. 4 The tax benefit can be less than the deferred tax asset if the amount realized is less than the value of the options estimated at the grant date. In this case, the amount by which the deferred tax asset exceeds the realized tax benefit reduces paid-in capital from prior exercises. Once paid-in capital from prior exercises reaches zero, the remainder is reported as tax expense in the current period.

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earnings predictor, especially if (1) the tax benefit has different predictive content for future

earnings compared to other operating cash flows, and (2) investors fail to distinguish the tax

benefit from other operating cash flows when analyzing financial statement information.

2.2 Characteristics of the Tax Benefit from Employee Stock Options

The tax benefit is likely to differ from other operating cash flows in its relation with

future earnings because it has characteristics in common with both operating and financing

activities, as evidenced by the debate on its appropriate classification. The tax benefit is similar

to operating activities to the extent that employee stock options represent compensation expense,

which is an operating activity, and tax savings on operating expenses should be classified as

operating activities. However, option compensation differs from most other forms of

compensation because its amount tends to be out of the firm’s control. The most significant

determinant of option exercises is recent stock price performance (e.g. Huddart and Lang 1996).

Although management can indirectly affect stock returns, it is not directly controllable like other

cash-based compensation.

The tax benefit also has characteristics that are similar to other financing activities. In

particular, the tax benefit is realized if, and only if, the company issues equity. In that regard, it

is conceptually similar to the proceeds the firm receives from employee exercises of options (i.e.

the ‘strike price’), which are treated as financing cash flows. Also, the tax benefit tends to be

clustered in years of recent good stock price performance which is more consistent with it being

a financing cash flow.

The tax benefit may nevertheless have a strong positive relation with future earnings.

Exercises tend to occur in years of superior stock price performance. Prior research shows that

stock prices have significant information content for future earnings (Beaver, et al., 1980). Thus,

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the tax benefit could occur in the period when good news arrives but before that news is

incorporated into earnings. On the other hand, Bartov and Mohanram (2004) show that large

option exercises precede significant declines in firm and stock price performance, consistent with

earnings management to boost current earnings and stock prices. Thus, the future reversal of

current period earnings management associated with the exercise of options could cause the tax

benefit to have a significant negative relation with future earnings. However, because Bartov and

Mohanram examine firms with exercises at least 50 percent larger than the average of the prior

three years’ exercises, their result may not generalize to the average firm with tax benefits from

employee stock options. Ultimately, the relation between the tax benefit and future earnings is

unclear ex ante.

2.3 The tax benefit and future returns

The ability of the tax benefit to predict returns will depend on the implications of the tax

benefit for future earnings and on the extent to which investors attend to those implications in

valuing the stock. If the tax benefit has no implications for future performance, as some

speculate (e.g., Mulford and Comiskey 2005), then the earnings fixation hypothesis predicts no

pricing effect. This is because the tax benefit does not affect the calculation of contemporaneous

earnings during our sample period, and the earnings fixation hypothesis holds that investors do

not attend to the cash flow and accrual components of earnings. Thus, no pricing effect occurs

because investors are essentially ignoring noise.

However, recent research suggests that investors do identify differences in the persistence

of cash flows. Specifically, Dechow, Richardson, and Sloan (2008) find that prices behave as if

investors fully understand the implications of cash flows between the firm and owners (as well as

creditors), but do not understand the future implications of cash flows reinvested in the firm’s net

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assets. This is important to our study for two reasons. First, it suggests a more nuanced pricing of

cash flows than indicated by prior work (e.g., Sloan, 1996). Second, to the extent investors

understand the future earnings implications of cash flows from transactions with owners, the

Dechow, Richardson, and Sloan (2008) results predict no pricing effect for the tax benefit. These

considerations preclude a clear prediction on the pricing effects of the tax benefit, even if the tax

benefit has implications for future earnings.

2.3 Reporting the tax benefit in the operating and financing sections

Regardless of the conceptual debate over the appropriate placement of the tax benefit in

the statement of cash flows, the accounting under FAS 123R suggests that a significant portion

will continue to be placed in the operating section. Moreover, the new rules under FAS 123R

actually mask the implications of the tax benefit. Before FAS 123R, the entire tax benefit was

reported in the operating section, often as a separate line item. Thus, the tax benefit from

employee stock options could be easily identified and removed, if users so desired. Under the

new rules, the tax benefit is no longer listed as an item in the operating section, but rather as a

part of the change in the deferred tax asset account. Although FAS 123R requires firms to

furnish sufficient information to identify the total amount of the tax benefit from employee stock

options, this information can appear in a number of places in the footnotes, reducing the

likelihood that users will find the tax benefit and attend to its consequences (Maines and

McDaniel 2000).

Based on the prior discussion, it is clear that several features of this item make it likely

that it will exhibit different properties from other operating cash flows. Using our sample, we can

estimate these implications and examine how investors price the tax benefit for firms that

separately disclose it. Although we cannot know how investors will price this item in the future,

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the recent changes are likely to reduce the extent to which investors identify and attend to the

differences between the tax benefit and other operating cash flows.

In the next sections, we examine the persistence and predictive content of the tax benefit

and compare it to other components in the operating section of the statement of cash flows. We

then examine the market’s interpretation of the tax benefit to assess whether the market

distinguishes it from other operating cash flows.

3. Sample

We draw our sample from Capital IQ, a division of Standard & Poor’s. Capital IQ

collects data from SEC filings, and covers the universe of firms that file annual reports with the

SEC. Capital IQ provides detailed financial statement data and several data items from footnotes,

including the tax benefit from employee stock options and footnote disclosures for stock

compensation expense and pro forma net income under FAS 123. The time series of data is

limited to the 1997 through 2006 period, which covers the entire time frame for which the tax

benefit was a required component of the operating section on the statement of cash flows.

Capital IQ reports 6,080 firm-year observations for 1,644 firms that report the tax benefit

in the statement of cash flows. We are unable to match our sample with CRSP for 242 of these

observations.5 Of the remaining 5,838 firm-years, we lose 1,028 for holding periods that begin

after January 2006 and an additional 233 for observations without a full year of

contemporaneous returns (e.g., IPO firms). Our final sample includes 4,577 firm-year

observations for 1,359 firms. We lose 157 observations in tests that require one-year-ahead

earnings.6 For our asset pricing tests, we sort firms based on prior year cutoffs resulting in a loss

5 For comparison, of the 8,147 observations in Compustat in 2005, 2,151 (26.4%) cannot be matched to CRSP. 6 Kraft, Leone, Wasley (2005) find that sample selection biases can affect the accrual anomaly. This is unlikely to be an issue in our study because the effects we document are the largest for firms that have large increases in stock

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of 317 observations in 1998. To avoid the concern that our results might be driven by micro-cap

firms, we exclude 246 observations with market capitalizations less than $50 million, resulting in

a final sample of 4,017 for our asset pricing tests.7 We calculate delisting returns following the

procedures in Beaver, McNichols, and Price (2007).

Because of Capital IQ’s data collection procedure, our sample excludes firms that have

no tax benefits from employee stock options, as well as firms that have a tax benefit but do not

report it as a separate line item in the operating section.8 Thus, our analysis is conditional on the

firm both (1) having a tax benefit and (2) reporting it separately on the statement of cash flows.

Although this excludes some firms with tax benefits from our analysis, our sample is partitioned

on a firm characteristic that is identifiable ex ante, such that our sample selection procedure is

replicable and the asset pricing tests are implementable. In fact, our sample includes the firms

where investors are most likely to correctly price the tax benefit, as investors can determine the

amount of the tax benefit without examining the footnotes or the statement of shareholders

equity.9

We report descriptive statistics about the tax benefit in Table 1. The number of

observations generally rises over the period, reflecting the increased use of stock option plans in

employee compensation arrangements. The number of observations declines dramatically in

2006, and represents almost entirely firms whose fiscal periods ended in 2006 before the

price which are unlikely to leave the sample due to financial distress and bankruptcy. We do not have this restriction for the hedge portfolio tests because they do not require future earnings. 7 In subsequent tests, we include all firms, as well as increase the market capitalization cutoff to require firms be greater than $250M and greater than $500M market capitalization. All results are available upon request. 8 Firms that aggregate the tax benefit with other items of operating cash flows often report the tax benefit in the statement of stockholders’ equity, the tax footnote, or the option footnote. Because our data only includes firms that report the tax benefit as a separate line item on the statement of cash flows, these firms are not included in our sample. 9 Also note that all tests are conducted “in-sample” whereby we have no analysis comparing firms with tax benefits to firms without tax benefits. This would be problematic because our dataset does not allow us to distinguish firms without a tax benefit from firms with a tax benefit that is not reported on the statement of cash flows.

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effective date of FAS 123R. For firms adopting 123R in 2006, the tax benefit disappears from

the operating section for a couple of reasons. First, the disclosure norm appears to have changed,

as most firms stopped reporting the tax benefit from employee stock options separately in the

operating section with the adoption of FAS 123R, instead including it with the change in

deferred taxes.

Second, the tax benefit for options accounted for under FAS 123R only affects operating

cash flows if a deferred tax asset already exists for the options that are being exercised. A

deferred tax asset will only exist if the options were expensed when granted. Because less than

10% of companies voluntarily expensed stock option compensation under FAS 123 (Barth et al.

2004), relatively few companies will have deferred tax assets for options granted before 2006.

For all other firms, the entire tax benefit arising from employee exercises of these options will be

considered ‘excess’ and classified in the financing section. This latter effect is transitory and

will only persist until employees start exercising options that have been expensed under FAS

123R. It will likely take a couple of years for employees to begin to exercise option grants that

have been made under FAS 123R, but when this happens, the amount of tax benefits included in

operations will rise significantly.

The economic significance of the tax benefit is also clear in Table 1 where we report the

tax benefit as a percent of lagged total assets.10 On average, the tax benefit amounted to 1.57

percent of lagged total assets. For comparison, yearly median ROAs for the Compustat

population range from 0.36 to 2.41 percent over this period while the median ROA for firms in

our sample is approximately 7.2 percent. Although the tax benefit does not affect the

computation of net income, its classification in the operating section on the cash flow statement

10 Brown and Lee (2007) find that option grants to top executives decline after FAS 123R. Option grants nevertheless remain economically important, amounting to 1 percent of weighted average shares outstanding for our sample firms in 2006. This is down from a high of 3 percent in 2001.

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does affect the computation of accruals and operating cash flows. Thus, the tax benefit accounts

for a substantial shift in the contribution of cash flows and accruals to ROA.

We report descriptive statistics for our regression variables in Table 2. Except for stock

returns, all variables are winsorized at the 1st and 99th percentiles to control for the influence of

outliers. The difference between return on assets (ROA) and pro forma return on assets

(PF_ROA), which includes option based compensation expense, is 2.4 percent of lagged total

assets, suggesting that recognition of stock compensation expense would have resulted in

substantial reductions in profitability for our sample firms. Also note that the median ROA for

our sample (7.2%) is significantly higher than the median ROA for the entire Compustat

population (1.6%). Although we do not explicitly screen on losses, a disproportionate number of

loss firms will not have tax benefits either because (i) they have not paid taxes in the past and do

not generate a tax benefit, or (ii) poor economic performance has resulted in little or no options

being exercised. On the other hand, firms with very strong recent economic performance are

more likely to generate large tax benefits, and thus be included in our sample. Consequently, our

sample firms have higher ROA than the Compustat population.

We report correlations in Table 3, with Pearson correlations above the diagonal and

Spearman correlations below. The tax benefit from employee stock options (TBESO) possesses a

relatively weak Pearson correlation with one-period-ahead ROA (correlation = 0.03). In contrast,

other operating cash flows, defined as total cash from operations minus the tax benefit

(AdjCFO), possesses a strong correlation with future ROA (correlation = 0.48). The tax benefit is

significantly related to contemporaneous cash flows (Pearson correlation = 0.42), although this is

overstated because operating cash flows includes the tax benefit. Adjusting operating cash flows

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by removing the tax benefit reveals a markedly smaller correlation between the tax benefit and

other operating cash flows (Pearson correlation = 0.21).

4. Results

4.1 The Persistence of the Tax Benefit from Employee Stock Options

Given the substantial magnitude that the tax benefit can achieve, we first evaluate the

extent to which the tax benefit behaves similarly to other operating cash flows. We begin by

comparing the time-series persistence of the tax benefit from employee stock options to the

persistence of other operating cash flows. Specifically, we estimate the following models for the

firms in our sample:

i ,t 1 0 1 i ,t 2 i ,t 3 i ,t 4 i ,t i ,t 1CFO TBESO AdjCFO ACC RETα α α α α ε+ += + + + + + (1)

i ,t 1 0 1 i ,t 2 i ,t 3 i ,t 4 i ,t i ,t 1TBESO TBESO AdjCFO ACC RETα α α α α ε+ += + + + + + (2)

i ,t 1 0 1 i ,t 2 i ,t 3 i ,t 4 i ,t i ,t 1AdjCFO TBESO AdjCFO ACC RETα α α α α ε+ += + + + + + (3)

where TBESOi,t denotes the tax benefit from employee stock options for firm i in period t, CFOi,t

denotes the cash from operations for firm i in period t, AdjCFOi,t denotes the cash from

operations minus the tax benefit from employee stock options for firm i in period t, ACCi,t

denotes accruals for firm i in period t, calculated as net income minus cash flows from

operations, and RETi,t denotes the contemporaneous annual stock return for firm i in period t.

Except for RET, all variables are scaled by total assets at the beginning of the period. If the tax

benefit has similar properties to other items of operating cash flows, α1 should be similar to α2 in

these regressions. However, if the tax benefit is more transitory than other operating cash flows,

α1 should be less than α2. In addition, because option exercises are more likely to follow stock

price increases, the tax benefit should more strongly relate to returns than do other operating cash

flows.

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Because we employ pooled cross-sectional time-series regressions, our regression

residuals are likely to suffer from serial correlation. Also, based on the discussion in section 2,

our regressions are likely to exhibit substantial cross-correlation in the residuals, because

economy-wide shocks will be a factor in determining the magnitude of the tax benefit. To

account for this, all regression specifications use robust standard errors that are clustered by firm

and year (see Wooldridge 2002 and Petersen 2005).

Table 4 provides the results of estimating equations (1), (2) and (3). The first column in

Table 4 shows the relation between future unadjusted cash from operations and current period

earnings components. This regression is similar in nature to Barth, Cram, and Nelson (2001), but

decomposes current period operating cash flows instead of accruals. We find that the tax benefit

has a weaker relation with future cash flows than do other items of current year operating cash

flows (TBESO = .33, AdjCFO = .58). The difference is statistically significant (F = 22.89, p <

.0001). The next column in Table 4 shows the persistence of the tax benefit in a univariate

setting. We find that the persistence of TBESO is low (coefficient = 0.31, t-value = 3.41). In

comparison, the fifth column of Table 4 shows persistence of other operating cash flows in a

univariate setting. Notice that the coefficient in column 5 indicates substantially stronger time-

series persistence for AdjCFO (coefficient = 0.54, t-value = 12.34).

When we include accruals and the other items of operating cash flows, we find that the

relation between the tax benefit and prior period earnings components is economically small

(AdjCFO = 0.04, t-value = 7.70; ACC = 0.02, t-value = 4.53) but the relation between other

operating cash flows and these metrics is much stronger (AdjCFO = 0.61, t-value = 16.23; ACC

= 0.15, t-value = 7.24). The fourth and seventh columns report results including lagged returns.

The tax benefit is significantly related to lagged returns (coefficient = 0.01, t-value = 6.45), while

18

other operating cash flows are not (coefficient = 0.009, t-value = 1.34). Finally, the tax benefit

and other operating cash flows significantly differ in their implications for future cash flows. For

example, column 4 shows that the tax benefit has a significantly stronger relation with future tax

benefits compared to other operating cash flows (F = 472.68, p < .0001), while column 7 shows

that the tax benefit has a significantly weaker relation with other future operating cash flows (F =

86.81, p < .0001).

These results provide our first evidence that the tax benefit significantly differs from

other operating activities. In particular, current period operating metrics are largely irrelevant for

predicting future realizations of the tax benefit from employee stock options. Moreover, we

consistently find significant differences in the implications of the tax benefit and other operating

cash flows for future cash flows. In contrast, the tax benefit has a statistically strong relation with

past stock price performance.

4.2 The Predictive Ability of the Tax Benefit and Other Operating Cash Flows

Next, we examine whether the tax benefit differs from other operating cash flows in its

predictive content for future profitability. Compared to other components of current period cash

flows, the tax benefit could have a substantially different relation with future performance. In

particular, the tax benefit arises from the issuance of equity. Thus, these cash flows are more

transitory, as documented in Table 4, and seem less directly related to fundamental performance

of the firm in the period of exercise. On the other hand, the tax benefit is significantly related to

contemporaneous and lagged stock returns, and research has shown that returns lead earnings.

Therefore, including the tax benefit might improve the prediction of future earning to the extent

that it captures earnings related information in returns that is not reflected in other earnings

components (e.g. Collins, Kothari, Shanken, Sloan 1994).

19

We examine the predictive content of accruals and cash flows when the tax benefit is

included in the operating section by regressing one-period-ahead ROA on current period

earnings components:

1t,it,i2t,i101t,i ACCCFOROA ++ ε+α+α+α= (4)

1t,it,i3t,i2t,i101t,i ACCTBESOAdjCFOROA ++ ε+β+β+β+β= (5)

1t,it,i2t,i101t,i AdjACCAdjCFOROA ++ ε+δ+δ+δ= (6)

where ROA denotes net income for firm i in period t and AdjACC denotes accruals plus the tax

benefit of employee stock options for firm i in period t. The first specification provides a

benchmark estimation of the relation between current earnings components and future

profitability under pre-FAS 123R rules. The second specification removes TBESO from CFO to

demonstrate the differences in implications for future profitability possessed by the tax benefit

and other cash flow items. The third specification adds TBESO to ACC to demonstrate the

predictive content of cash flows and accruals if the tax benefit is entirely removed from the

operating section of the statement of cash flows.11 The comparison of equations (4) and (6) is

most relevant, as it represents the case where the tax benefit is included in operations versus the

case where it is removed from operations, with no additional information provided.

We present the results in Table 5. The first set of results show a significant positive

relation between current period earnings components and future profitability. In the second

specification, however, we show that TBESO is not significantly associated with future

profitability, and actually has a negative but insignificant sign (TBESO = -0.21, t-value = -1.21).

11 We define accruals as the difference between net income and cash flows from operations. Consequently, taking the tax benefit out of the operating section requires a decrease in operating cash flows and a corresponding increase in accruals. An alternative definition of accruals is the change in working capital accounts on the balance sheet minus non-cash charges such as depreciation and amortization. Using this alternative definition of accruals in model (4) results in almost mechanical changes to the results, with negligible effects on overall model fit.

20

The results also show a large increase in the coefficient on AdjCFO relative to CFO, consistent

with significant differences in the implications of TBESO and AdjCFO for future performance.

The second specification shows marked improvement in fit, as the adjusted R-square rises from

33.08 percent to 37.28 percent.

The third specification (eqn. 6) examines the hypothetical situation where none of the tax

benefit is included in the operating section. Results for the third specification show a decline in

the explanatory power relative to the second specification (35.05 percent compared to 37.28

percent), which is expected because econometrically it constrains the coefficient on TBESO to be

the same as the coefficient on ACC, necessarily resulting in a loss of fit. However, the important

comparison is that the third specification still represents an improvement over the first

specification (R-square of 35.05 percent compared to 33.08 percent). If removing the tax benefit

from the operating section improves the predictive content of earnings components for future

earnings, the explanatory power of model (6) should be significantly greater than the explanatory

power of model (4). A Vuong (1989) test of non-nested models confirms this prediction (Z =

5.03, p < .0001).

During our sample period, the vast majority of firms do not recognize stock

compensation expense. Thus, the results in Table 5 could fail to reflect the relations that will

exist under FAS 123R. This could occur, for example, if controlling for stock compensation

expense alters the relation between the tax benefit and future profitability. To address this

concern, we also report results using pro forma net income under FAS 123. Capital IQ records

the footnote disclosures of pro forma net income required under FAS 123. Using these footnote

disclosures, we reconstruct earnings and accruals as if these amounts were recognized in the

financial statements. One caveat, however, is that prior research shows that accounting choices

21

change if firms are required to recognize versus disclose (e.g., Aboody 1996), and the pro-forma

amounts we use were only disclosed (i.e., not recognized). However, we are unaware of any

reason why potential differences in the actual recognized amounts would systematically bias our

inferences.

We view our results from this analysis as ex ante evidence of the predictive content of

accruals, cash flows, and the tax benefit under the new regime mandated by FAS 123R. As

mentioned earlier, companies will now include only part of the tax benefit in the operating

section if the value realized by the employee exceeds the estimated option value at the grant date.

Thus, our results reflect the special case where, at the grant date, all firms either exactly estimate

or overestimate the value that the employees will ultimately realize at exercise. Although clearly

unrealistic, this scenario reflects the most conservative grant date measurement of option values.

We re-estimate equations (3), (4), and (5) replacing net income with FAS 123 pro forma

net income in defining PF_ROA and PF_ACC:

1t,it,i2t,i101t,i ACC_PFCFOROA_PF ++ ε+α+α+α= (4’)

1t,it,i3t,i2t,i101t,i ACC_PFTBESOAdjCFOROA_PF ++ ε+β+β+β+β= (5’)

1t,it,i2t,i101t,i AdjACC_PFAdjCFOROA_PF ++ ε+δ+δ+δ= (6’)

We report the results in Table 6. The first specification shows that cash flows and pro forma

accruals possess modest explanatory power for future profitability (adjusted R-square = 34.75

percent). The value of stock compensation expense measured at the grant date is amortized over

the vesting period, usually in equal installments. Thus, the current period stock compensation

accrual is relatively permanent, and this is confirmed by the increase in the coefficient on

PF_ACC relative to ACC reported in Table 5.

22

The second specification distinguishes the tax benefit from employee stock options from

other operating cash flows. The tax benefit is significantly negatively related to future earnings

including option expense (TBESO = -0.35, t-value = -2.58). In contrast, other operating cash

flows and accruals possess a positive relation with future profitability (AdjCFO = 0.72, t-value =

19.84, PF_ACC = 0.50, t-value = 13.08). The adjusted R-square improves to 39.47 percent. In

the final column, we report results removing the tax benefit from the operating section by adding

TBESO to PF_ACC to define pro-forma adjusted accruals (PF_AdjACC). This model also

displays an improvement in explanatory power relative to the benchmark specification, with an

adjusted R-square of 35.99 percent. The Vuong (1989) test rejects equation (4’) in favor of

equation (6’) (Z-stat = 4.50, p<0.001), suggesting that earnings components have greater

predictive content for future profitability if the tax benefit is completely removed from the

operating section.

Overall, these results confirm that the tax benefit has different properties compared to

other operating cash flows. Not only does the tax benefit display lower autocorrelation, but also

has a stronger relation with past returns and a weaker relation with future earnings. In the next

section, we examine whether investors detect these differences in the properties of the tax benefit

and other operating cash flows.

4.3 The Pricing of Operating Cash Flows and the Tax Benefit

Thus far, our analysis examined how the classification of the tax benefit affects the

usefulness of earnings components. In this section, we evaluate how the tax benefit is priced

when included in operating cash flows. Ideally, we would also like to compare the pricing of

this component when placed in the operating section relative to the pricing when it is placed in

the financing section. Because of the lack of observations post-FAS 123R where part of the tax

23

benefit is reclassified as financing, however, we are only able to estimate the market’s implied

persistence relative to a rational expectation of persistence for amounts reported in the operating

section.

Following Sloan (1996), we use a system of equations that predicts future earnings based

on current earnings, decomposed into accruals and cash flows. The coefficients from this

forecasting equation represent a rational expectation of the extent to which these components

predict future earnings. The second equation (i.e. the pricing equation) uses the market reaction

over the following year to infer the pricing of these individual components, and compares these

to the rational expectation estimated in the forecasting equation.

We therefore estimate the following system of equations:

1t,it,i3t,i2t,i101t,i ACCTBESOAdjCFOROA ++ ε+β+β+β+β= (7)

[ ( )] 1t,it,i*3t,i

*2t,i

*1

*01t,i1t,i ACCTBESOAdjCFOROABHSAR +++ η+β+β+β+β−γ= (8)

where BHSAR denotes the annual buy-and-hold size-adjusted return for firm i starting three

months after fiscal year end.

We report the results in Table 7. Examining the pricing of operating cash flows excluding

the tax benefit, we find rational pricing of AdjCFO (Likelihood Ratio = 0.13, p = 0.721) for our

sample of firms. In contrast, we find that TBESO, a component of operating cash flows, is

significantly overpriced (Likelihood Ratio = 18.86, p < 0.001). Moreover, we find that the

pricing of the tax benefit is not significantly different than the pricing of other operating cash

flows (Likelihood Ratio = 2.18, p = 0.1398, not tabulated). Unexpectedly, we find no mispricing

of accruals (LR = 0.18, p = 0.671). The fact that the accrual mispricing is not significant in our

results is likely due to at least a couple of factors. First, our sample represents the larger firms,

where the accrual anomaly is most likely to be arbitraged (e.g. Mashruwala, Rajgopal and

24

Shevlin 2004). Second, our sample period is entirely post-Sloan (1996), and represents a time of

increased quantitative hedge fund trading which is likely to incorporate the accruals signal.12

For completeness, we also report the same analysis using pro-forma ROA, where stock-

based compensation has been treated as an expense. This situation is more analogous to the

earnings that will be reported under FAS 123R. By using pro forma income and accruals, we are

also able to add to the recent research on the market’s pricing of footnote disclosures. For

example, Ge (2006) examines the market’s pricing of minimum operating lease obligations,

finding that the market underprices this footnote information. We also distinguish the accrual for

stock compensation expense from other accrual components to provide preliminary evidence on

its persistence and potential mispricing, and to make sure our effects are not simply caused by

the propensity to grant employee stock options. We therefore estimate the following equations:

, 1 0 1 , 2 ,

3 , 4 , , 1

__

i t i t i t

i t i t i t

PF ROA AdjCFO TBESOACC STOCK COMP

β β β

β β ε+

+

= + +

+ + + (7’)

()

* * *, 1 , 1 0 1 , 2 ,

* *3 , 4 , , 1

_

_

i t i t i t i t

i t i t i t

BHSAR PF ROA AdjCFO TBESO

ACC STOCK COM P

γ β β β

β β η

+ +

+

⎡= − + +⎣

⎤+ + +⎦

(8’)

where STOCK_COMP denotes the FAS 123 pro forma stock compensation expense accrual for

firm i in period t, calculated as pro forma accruals minus reported accruals (PF_ACC – ACC).

Results of this analysis are presented in Table 7, panel B, and are largely consistent with the

results in Panel A that use as-reported ROA. The tax benefit is significantly overpriced, while

other operating cash flows are not significantly mispriced. One interesting aside is that in the

FAS 123 period, stock-based compensation does not appear to be priced by the market

12 In untabulated results we also include twelve month-prior returns in the forecasting and pricing equations to control for the potential effect of momentum, and this does not alter our inferences.

25

(β4=0.662, β4* = 0.148,), possibly due to its placement in the footnotes instead of income

statement recognition.

Overall our results suggest that when the tax benefit is included in the operating section

of the statement of cash flows, prices do not adequately reflect lower persistence of the tax

benefit relative to other operating cash flows. Moreover, this result obtains in a sample of firms

where the tax benefit is explicitly disclosed in the operating section of the statement of cash

flows.

To provide more sophisticated returns-based analysis that controls for various other risk

factors, we provide a number of additional asset pricing tests. We examine both cross-sectional

and time series tests of the pricing of portfolios formed on the magnitude of the reported tax

benefit. Table 8, panel A provides cross-sectional regression of decile rankings of the tax

benefit, and a number of additional control variables including accruals, operating cash flows,

book to market, momentum, and size. All variables are ranked and scaled between 0 and 1 using

the prior year’s distribution of the variable to provide theoretically implementable portfolio

returns (e.g. Abarbanell and Bushee 1998).

When included by itself, the TBESO rank variable generates a hedge return of

-16.8% (p=0.046). Conditional on including decile ranks of accruals, cash flows, book to

market, momentum, and size, the abnormal return drops to -14.1% (p=0.094), which is still

marginally significant. Notice further that because the sign on TBESO is the opposite of the sign

on operating cash flows, a cash flow based strategy will perform significantly worse if the tax

benefit is not first removed from operating cash flows.

Although we exclude the smallest firms from our analysis, there is still the concern that

our results are due to firms that are much smaller than firms that institutional investors tend to

26

trade in. Therefore, we provide an additional column that excludes all firms with market

capitalization less than $500M (labeled ‘Large Firms Only’). Similar to the analysis on the full

sample, the analysis on large firms shows a negative association between current tax benefits and

future returns (t-stat = -2.48, p-value = 0.013).13

Panel B provides calendar time portfolio returns using the four factor model (Fama and

French 1993, Carhart 1997). Portfolios are equally weighted and rebalanced monthly, taking

long positions in firms with the below-median tax benefits and short positions in firms with

above-median tax benefits. The results in Table B show a positive intercept of 66 basis points

per month, or approximately 7.9% annually. The intercept is significant, with a t-statistic of 1.97

(one-sided p-value = 0.026). Moreover, this result is obtained with a relatively short time series

(7 years or 84 monthly returns). Also notice that the hedge portfolio formed on the tax benefit

has significant exposure to both the market factor and book to market, suggesting high tax

benefit firms have higher betas and higher market to book ratios. Similar to the cross-sectional

asset pricing tests, the results are statistically stronger when only large firms are considered.

Additional untabulated results examine the intertemporal stability of the hedge portfolio

returns over our 7 year period. Overall, the returns are positive in 6 of the 7 years, with the one

negative portfolio return of 7.4% occurring in 2004. However, the relatively short time series of

data makes it difficult to generalize our result.

As a final test, we attempt to disentangle whether the observed patterns in stock returns

are due to the underpricing of the negative signal associated with option exercises or the increase

in operating cash flows resulting from classifying the tax benefit as part of operations. Because

the tax benefit arises from option exercises, it could be the case that the poor future returns are an

13 These results are robust when we restrict our sample to even larger firms. For example, when we exclude firms with market values less than $1 billion, the tax benefit decile portfolio assignment continues to negatively relate to future returns (estimate = -.202, t-statistic = -1.94).

27

underreaction to the negative news conveyed by large option exercises (Bartov et al. 2004).

Although there is a strong correlation between option exercises and the tax benefit, we can take

advantage of the fact that some option exercises result in fewer tax benefits, such as exercises of

incentive stock options, or widespread exercises of options that are not deep in the money. Thus,

we include total options exercised divided by total options outstanding as an additional variable

in the cross-sectional returns regressions. The results are presented in Table 9. We find that the

decile ranking of option exercises is negatively related to future returns, although not significant

suggesting that investors adequately price the signal conveyed by large option exercises

(coefficient=-0.071, one sided p-value=0.15). More importantly, the tax benefit continues to be

negatively related to future returns even after including a variable capturing options exercised

(coefficient=-0.148, one sided p-value=0.07), suggesting that the cash flow effect is responsible

for our results and not simply option exercises.

5. Additional analysis

5.1 The Tax Benefit and Future Accruals

Table 4 provides evidence that the tax benefit is positively associated with future cash

flows, while Tables 5, 6, and 7 show no relation between the tax benefit and future earnings.

This appears to be consistent with the results in Bartov and Mohanram (2004), who find that

large exercises precede declines in stock prices, likely due to undetected earnings management in

the current period that reverses in future periods. Thus, current period TBESO could correlate

with the future reversal of current period accrual distortions. To explore this possibility, we

regress future accruals on the current period tax benefit:

1t,it,i3t,i2t,i101t,i ACCTBESOAdjCFOAccruals ++ ε+β+β+β+β= , (9)

28

where Accrualsi,t denotes either ACC or AdjACC for firm i in year t. If the tax benefit correlates

with current earnings management attempts that reverse next period, then TBESO will be

negatively related to future accruals.

We report the results in Table 10. We find that TBESO negatively relates to future ACC

(TBESO = -0.766, t-value = -5.48) and future AdjACC (TBESO = -0.473, t-value = -3.07). This

result is consistent with the evidence in Bartov and Mohanram (2004), which suggest that large

exercises occur when firms engage in income-increasing earnings management that reverse in

the following period. However, this interpretation requires that (i) a substantial portion of the

exercises is due to top management exercising options, and (ii) that these exercises are not

indicators of upcoming bad economic news. To assess the first assumption, we use Capital IQ

data on management exercises and find that option exercises by top management account for

25.1% of total option exercises on average for our sample firms. For the second assumption, we

note that the tax benefit is unlikely to be an indicator of upcoming bad economic news because

Table 4 reports that the tax benefit is not associated with lower future cash flows. We leave

further analysis on this issue to future research.

5.2 Sensitivity checks

In addition to our main analyses, we conduct various sensitivity checks to ensure the

robustness of our results. First, we examine the extent to which returns cluster around earnings

announcements for firms in extreme tax benefit portfolios. Earnings announcement window

returns for the low tax benefit decile portfolio exceed those for the high decile portfolio by .65%

(t-statistic = 1.84). This difference in returns is unlikely to be explained by risk; the returns

earned around earnings announcements are approximately 15.5 percent of the hedge returns

(.65% x 4 earnings announcements / 16.8% hedge return = 15.5%). If expected returns are

29

earned evenly over the year and the abnormal returns are due to an omitted risk factor, we expect

4.8 percent of the hedge return to be earned over the 12 days surrounding earnings

announcements (12 earnings announcement days / 252 trading days in a year = 4.8%). Thus, the

returns earned around earnings announcements are more than three times as large as we would

expect if risk explains the differences in returns across portfolios. Portfolios formed using

quintiles exhibit stronger significance, with the lowest tax benefit quintile outperforming the

highest tax benefit quintile by 0.75% (t = 3.10).

In our main analyses, we winsorize all variables at the 1 percent and 99 percent levels. To

assess the sensitivity of our results to this treatment of outliers, we also conducted our tests

before winsorizing. Our inferences in Tables 3, 4, 5, and 8 are unchanged. In Table 7, only stock

compensation expense is mispriced. However, if we remove 65 observations with buy and hold

size-adjusted returns greater than 200 percent (Kraft, Leone, and Wasley 2005), our results

indicate mispricing of both the tax benefit and the stock compensation expense.

6. Conclusion

In this paper, we examine the predictive content and the market pricing of the tax benefit

from employee stock options. The classification of items within the statement of cash flows is an

interesting issue that has received very little attention in the accounting literature. Conceptually,

the tax benefit has characteristics in common with both operating and financing activities. The

tax benefit is similar to operating cash flows because it arises from a compensation arrangement

with employees and has an impact of the firm’s tax liability. The tax benefit is similar to

financing cash flows because it stems from transactions with owners. This similarity to both

operating and financing activities partially explains the inconsistent treatment of the tax benefit

on the statement of cash flows: from 2000 to 2006, the tax benefit was generally required to be

30

reported in the operating section; with the adoption of FAS 123R, the tax benefit is split between

the operating and financing sections. The classification of the tax benefit from employee stock

options in the operating section could reduce the usefulness of operating cash flows in predicting

future earnings, especially if (1) the tax benefit has different predictive content for future

earnings compared to other operating cash flows, and (2) investors fail to treat the tax benefit

differently from other operating cash flows when analyzing financial statement information.

We first show that the empirical properties of the tax benefit differ from other operating

cash flows. The tax benefit is relatively transitory and has an economically insignificant relation

with past accruals and cash flows. We then document that the predictive content of the tax

benefit for future profitability significantly differs from that of other operating cash flows. While

operating cash flows generally posses a positive relation with future earnings, we show that the

tax benefit is not significantly related to future income. This result holds regardless of whether

we use actual net income and its components or use pro forma net income (and its components)

from the footnote disclosures required by FAS 123. We also show that the tax benefit has an

economically and statistically negative relation with future abnormal returns. Thus, prices

behave as if investors overprice the tax benefit, suggesting that investors do not recognize the

extent to which the tax benefit differs from other operating cash flows in its implications for

future earnings.

Overall, our results suggest that the new accounting under FAS 123R has the potential to

lead to differences in the quality of reported cash flows across firms, because the amount of the

tax benefit classified as cash from operations will depend on the original assumptions used on

the grant date. In fact, the accounting under 123R leads to the curious situation where more

conservative option accounting on the grant date increases the expected amount of tax benefit

31

included in operations when the options are exercised, thereby lowering the quality of reported

cash flows.

32

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River, NJ: Prentice Hall. Sloan, R., 1996, “Do stock prices fully reflect information in accruals and cash flows about

future earnings?” The Accounting Review, Vol. 71 (3): 289-315. Watts, R., 2003, “Conservatism in Accounting Part I: Explanations and Implications”,

Accounting Horizons, Vol. 17 (3): 207-221. Wooldridge, J. 2004, Econometric Analysis of Cross Section and Panel Data. MIT Press,

Cambridge, MA. Venkatachalam, M., S. Rajgopal, and P. Choudhary, 2006, “Accelerated Vesting of Employee

Stock Options in Anticipation of FAS 123-R, Working Paper, Duke University. Vuong, Q., 1989, “Likelihood ratio tests for model selection and non-nested hypotheses,”

Econometrica, Vol. 57 (2): 307-333.

35

Table 1. Magnitude of the tax benefit from employee stock options from 1998 through 2006 This table displays the magnitude of the tax benefit from employee stock options as a percentage of lagged total asssets for the period 1998-2006. The sample consists of 5,838 firm-year observations with available data for the tax benefit from employee stock options on Capital IQ.

Year N Mean Std Q1 Median Q3 Max 1998 362 1.88% 3.86% 0.23% 0.66% 2.02% 55.75% 1999 491 2.38% 5.22% 0.16% 0.63% 2.30% 58.33% 2000 590 3.41% 9.27% 0.17% 0.87% 2.94% 126.51% 2001 639 1.56% 3.06% 0.13% 0.50% 1.75% 31.24% 2002 739 0.96% 1.70% 0.09% 0.36% 1.04% 16.36% 2003 836 1.13% 2.57% 0.09% 0.30% 1.04% 42.03% 2004 910 1.34% 2.77% 0.15% 0.50% 1.40% 35.99% 2005 921 1.26% 3.65% 0.14% 0.49% 1.20% 90.45% 2006 350 0.80% 1.69% 0.08% 0.28% 0.75% 19.78%

Full Sample 5838 1.57% 4.27% 0.12% 0.47% 1.40% 126.51%

36

Table 2. Sample descriptive statistics This table displays sample descriptive statistics for our sample of firms from 1998 through 2005. The sample includes 4,577 firm-year observations from 1998 through 2005 drawn from Capital IQ. All variables other than returns and the book-to-market ratio are scaled by beginning of period total assets. ROA denotes net income. CFO denotes cash from operations (including the tax benefit from employee stock options). ACC denotes accruals, calculated as net income minus cash from operations. AdjCFO denotes cash from operations less the tax benefit from employee stock options. TBESO denotes the tax benefit from employee stock options. AdjACC denotes accruals plus the tax benefit from employee stock options. PF_ROA denotes pro forma ROA, calculated with the net income from FAS 123 footnote disclosure. PF_ACC denotes pro forma accruals, calculated as pro forma net income minus cash from operations. PF_AdjACC denotes PF_ACC plus TBESO. BTM denotes the book value of equity divided by market value at the end of the fourth month after fiscal year-end. BHSAR denotes annual buy-and-hold size adjusted returns beginning the fifth month after the end of the fiscal period. RET denotes the contemporaneous annual return. BTM denotes the ratio of common equity to market value at the end of the fourth month after fiscal year end. All variables except market value of equity are winsorized at the 1 percent and 99 percent levels.

Variable N Mean Std Minimum Median Maximum ROA(t+1) 4420 0.062 0.123 -0.732 0.066 0.514 ROA 4577 0.079 0.120 -0.631 0.072 0.654 CFO 4577 0.141 0.132 -0.326 0.127 0.785 ACC 4577 -0.063 0.113 -0.739 -0.056 0.591 AdjCFO 4577 0.126 0.123 -0.342 0.116 0.731 TBESO 4577 0.015 0.030 0.000 0.005 0.353 AdjACC 4577 -0.047 0.114 -0.739 -0.044 0.624 PF_ROA(t+1) 4420 0.041 0.132 -0.877 0.051 0.507 PF_ROA 4577 0.055 0.131 -1.193 0.055 0.616 PF_ACC 4577 -0.087 0.134 -1.329 -0.073 0.508 PF_AdjACC 4577 -0.071 0.127 -1.154 -0.062 0.541 BHSAR 4577 0.076 0.762 -1.428 -0.024 21.643 RET 4577 0.253 0.801 -0.891 0.106 8.552 BTM 4577 0.391 0.387 0.000 0.298 3.219 MVE ($MM) 4577 4119 20392 2 648 477625

37

Table 3. Correlation matrix for regression variables This table presents Pearson product moment correlations above the diagonal and Spearman rank correlations below the diagonal. The sample includes 4,577 firm-year observations from 1998 through 2005 drawn from Capital IQ. All variables other than returns and the book-to-market ratio are scaled by beginning of period total assets. ROA denotes net income. CFO denotes cash from operations (including the tax benefit from employee stock options). ACC denotes accruals, calculated as net income minus cash from operations. AdjCFO denotes cash from operations less the tax benefit from employee stock options. TBESO denotes the tax benefit from employee stock options. AdjACC denotes accruals plus the tax benefit from employee stock options. PF_ROA denotes pro forma ROA, calculated with the net income from FAS 123 footnote disclosure. PF_ACC denotes pro forma accruals, calculated as pro forma net income minus cash from operations. PF_AdjACC denotes PF_ACC plus TBESO. BTM denotes the book value of equity divided by market value at the end of the fourth month after fiscal year-end. BHSAR denotes annual buy-and-hold size adjusted returns beginning the fifth month after the end of the fiscal period. RET denotes the contemporaneous annual return. BTM denotes the ratio of common equity to market value at the end of the fourth month after fiscal year end. All variables except market value of equity are winsorized at the 1 percent and 99 percent levels. Entries in bold denote significance at the 5 percent level.

ROA(t+1) ROA CFO ACC AdjCFO TBESO AdjACC PF_ROA(t+1) PF_ROA PF_ACC PF_AdjACC BHSAR RET BTM MVE

ROA(t+1) 0.55 0.45 0.07 0.48 0.03 0.08 0.94 0.55 0.10 0.12 0.17 0.26 -0.37 0.06

ROA 0.64 0.59 0.35 0.55 0.33 0.44 0.47 0.90 0.29 0.38 -0.03 0.15 -0.44 0.07

CFO 0.54 0.65 -0.52 0.98 0.42 -0.41 0.36 0.46 -0.51 -0.44 -0.02 0.14 -0.38 0.13

ACC -0.07 0.11 -0.59 -0.52 -0.15 0.97 0.10 0.39 0.92 0.93 0.00 -0.02 -0.02 -0.07

AdjCFO 0.54 0.62 0.98 -0.60 0.21 -0.47 0.42 0.47 -0.47 -0.45 -0.01 0.13 -0.35 0.11

TBESO 0.33 0.53 0.47 -0.14 0.37 0.11 -0.11 0.09 -0.33 -0.12 -0.05 0.12 -0.27 0.12

AdjACC -0.02 0.20 -0.49 0.96 -0.54 0.03 0.07 0.41 0.83 0.90 -0.01 0.01 -0.09 -0.03

PF_ROA(t+1) 0.95 0.59 0.48 -0.04 0.50 0.22 -0.01 0.57 0.21 0.20 0.16 0.19 -0.29 0.04

PF_ROA 0.63 0.94 0.59 0.14 0.58 0.41 0.20 0.64 0.49 0.54 -0.02 0.14 -0.35 0.06

PF_ACC -0.08 0.06 -0.60 0.96 -0.60 -0.24 0.89 0.00 0.16 0.98 0.01 -0.01 0.04 -0.07

PF_AdjACC -0.04 0.14 -0.54 0.96 -0.56 -0.09 0.95 0.03 0.22 0.97 0.00 0.01 -0.03 -0.04

BHSAR 0.21 0.00 0.01 0.00 0.03 -0.10 -0.03 0.23 0.03 0.02 0.00 -0.02 0.07 -0.02

RET 0.36 0.16 0.15 -0.03 0.16 0.01 -0.02 0.36 0.19 0.00 0.00 0.01 -0.28 0.04

BTM -0.44 -0.51 -0.47 0.11 -0.42 -0.50 0.02 -0.36 -0.43 0.17 0.09 0.06 -0.31 -0.12

MVE 0.25 0.22 0.27 -0.13 0.25 0.25 -0.09 0.22 0.19 -0.14 -0.11 0.02 0.16 -0.46

38

Table 4. The persistence of the tax benefit from employee stock options This table presents regression results on the time-series persistence of the tax benefit from employee stock options. The sample includes 4,420 firm-year observations from 1998 through 2005 drawn from Capital IQ. All variables other than returns are scaled by beginning of period total assets. ROA denotes net income. CFO denotes cash from operations (including the tax benefit from employee stock options). ACC denotes accruals, calculated as net income minus cash from operations. AdjCFO denotes cash from operations less the tax benefit from employee stock options. TBESO denotes the tax benefit from employee stock options. RET denotes the contemporaneous annual return. We report t-statistics corrected for heteroscedasticity and correlation within cluster (by firm and year, see Petersen 2005). All variables are winsorized at the 1 percent and 99 percent levels. Models:

1t,it,i4t,i3t,i2t,i101t,i RETACCAdjCFOTBESOCFO ++ ε+α+α+α+α+α= (1)

1t,it,i4t,i3t,i2t,i101t,i RETACCAdjCFOTBESOTBESO ++ ε+α+α+α+α+α= (2)

1t,it,i4t,i3t,i2t,i101t,i RETACCAdjCFOTBESOAdjCFO ++ ε+α+α+α+α+α= (3)

N = 4420 (1) (2) (3) Estimate Estimate Estimate Estimate Estimate Estimate Estimate Variable (t-statistic) (t-statistic) (t-statistic) (t-statistic) (t-statistic) (t-statistic) (t-statistic) Intercept 0.044 0.006 0.003 0.002 0.046 0.045 0.044 (6.31) (5.63) (4.18) (1.62) (8.57) (7.89) (7.43) TBESO 0.325 0.309 0.284 0.259 0.124 0.101 (3.23) (3.41) (3.53) (4.17) (1.77) (1.40) AdjCFO 0.577 0.043 0.033 0.542 0.606 0.597 (13.31) (7.70) (8.43) (12.34) (16.23) (14.67) ACC 0.164 0.023 0.018 0.146 0.141 (9.44) (4.53) (4.01) (7.24) (8.73) RET 0.020 0.010 0.009 (3.06) (6.45) (1.34) Adj. R square 37.67% 16.36% 20.25% 32.42% 32.45% 33.81% 34.24% F Test: TBESOt = AdjCFOt 22.89 NA 456.85 472.68 NA 81.29 86.81 p-value <.0001 <.0001 <.0001 <.0001 <.0001

39

Table 5. The predictive content of operating cash flows, accruals, and the tax benefit from employee stock options for future earnings This table presents results from regressing one-period-ahead ROA on current period earnings components and the tax benefit from employee stock options. The sample includes 4,420 firm-year observations from 1998 through 2005 drawn from Capital IQ. Unless otherwise specified, the following variables are scaled by beginning of period total assets. ROA denotes net income. CFO denotes cash from operations (including the tax benefit from employee stock options). ACC denotes accruals, calculated as net income minus cash from operations. AdjCFO denotes cash from operations less the tax benefit from employee stock options. TBESO denotes the tax benefit from employee stock options. AdjACC denotes accruals plus the tax benefit from employee stock options. We report t-statistics corrected for heteroscedasticity and correlation within cluster (by firm and year, see Petersen 2005). All variables are winsorized at the 1 percent and 99 percent levels. Models:

1t,it,i2t,i101t,i ACCCFOROA ++ ε+α+α+α= (4)

1t,it,i3t,i2t,i101t,i ACCTBESOAdjCFOROA ++ ε+β+β+β+β= (5)

1t,it,i2t,i101t,i AdjACCAdjCFOROA ++ ε+δ+δ+δ= (6) (4) (5) (6) TBESO Adjusted TBESO included in CFO, TBESO, removed from Variable operating cash flow and accruals operating section Intercept 0.002 0.003 -0.002 (0.25) (0.51) (-0.25) CFO 0.628 (20.29) AdjCFO 0.727 0.670 (23.88) (26.57) TBESO -0.213 (-1.21) ACC 0.461 0.483 (10.30) (12.56) AdjACC 0.433 (9.12) Adj. R-square 33.08% 37.28% 35.05% N 4420 4420 4420 Vuong test of non-nested models Model (3) > Model (1) Z = 5.03, p < .0001

40

Table 6. The predictive content of operating cash flows, accruals, and the tax benefit for future FAS 123 pro forma earnings This table presents results from regressing one-period-ahead pro forma ROA on current period earnings components and the tax benefit from employee stock options. Pro forma ROA is based on the FAS 123 footnote disclosure. The sample includes 4,420 firm-year observations from 1998 through 2005 drawn from Capital IQ. Unless otherwise specified, the following variables are scaled by beginning of period total assets. CFO denotes cash from operations (including the tax benefit from employee stock options). AdjCFO denotes cash from operations less the tax benefit from employee stock options. TBESO denotes the tax benefit from employee stock options. PF_ROA denotes pro forma ROA, calculated with the net income from FAS 123 footnote disclosure. PF_ACC denotes pro forma accruals, calculated as pro forma net income minus cash from operations. PF_AdjACC denotes PF_ACC plus TBESO. We report t-statistics corrected for heteroscedasticity and correlation within cluster (by firm and year, see Petersen 2005). All variables are winsorized at the 1 percent and 99 percent levels. Models:

1t,it,i2t,i101t,i ACC_PFCFOROA_PF ++ ε+α+α+α= (4’)

1t,it,i3t,i2t,i101t,i ACC_PFTBESOAdjCFOROA_PF ++ ε+β+β+β+β= (5’)

1t,it,i2t,i101t,i AdjACC_PFAdjCFOROA_PF ++ ε+δ+δ+δ= (6’)

(4’) (5’) (6’) TBESO Adjusted TBESO included in CFO, TBESO, removed from Variable operating cash flow and accruals operating section Intercept -0.004 -0.003 -0.010 (-0.55) (-0.37) (-1.05) CFO 0.642 (20.48) AdjCFO 0.723 0.684 (19.84) (22.02) TBESO -0.351 (-2.58) PF_ACC 0.535 0.495 (22.73) (13.08) PF_AdjACC 0.502 (17.96) Adj. R-square 34.75% 39.47% 35.99% N 4420 4420 4420 Vuong test of non-nested models Model (3) > Model (1) Z = 4.50, p < .0001

41

Table 7. Mishkin analysis of the market’s pricing of cash flows, accruals, and the tax benefit, and stock compensation for future earnings This table presents results from estimating a system of forecasting and returns equations for ROA. The sample includes 4,420 firm-year observations from 1998 through 2005 drawn from Capital IQ. All variables other than returns are scaled by beginning of period total assets. ROA denotes net income. CFO denotes cash from operations (including the tax benefit from employee stock options). ACC denotes accruals, calculated as net income minus cash from operations. AdjCFO denotes cash from operations less the tax benefit from employee stock options. TBESO denotes the tax benefit from employee stock options. AdjACC denotes accruals plus the tax benefit from employee stock options. All variables are winsorized at the 1 percent and 99 percent levels. Panel A. Market’s pricing of operating cash flows, accruals, and the tax benefit from employee stock options

1t,it,i3t,i2t,i101t,i ACCTBESOAdjCFOROA ++ ε+β+β+β+β= (7) [ ( )] 1t,it,i

*3t,i

*2t,i

*1

*01t,i1t,i ACCTBESOAdjCFOROABHSAR +++ η+β+β+β+β−γ= (8)

(7) (8) LR Test of Equal Forecasting Returns Coefficients Variable Equation Equation LR p-value ERC 1.460 (13.51) Constant 0.005 -0.053 (0.72) (-4.61) AdjCFO 0.722 0.697 0.13 0.721 (23.37) (9.89) TBESO -0.240 0.891 18.86 <.0001 (-1.41) (3.49) ACC 0.470 0.503 0.18 0.671 (11.59) (6.67) N = 4,180

42

Panel B. Market’s pricing of operating cash flows, accruals, option compensation expense, and the tax benefit from employee stock options

1t,it,i4t,i3t,i2t,i101t,i COMP_STOCKACCTBESOAdjCFOROA_PF ++ ε+β+β+β+β+β= (7’) [ (

)] 1t,it,i*4t,i

*3

t,i*2t,i

*1

*01t,i1t,i

PCOM_STOCKACC

TBESOAdjCFOROA_PFBHSAR

+

++

η+β+β+

β+β+β−γ= (8’)

(7’) (8’) LR Test of Equal Forecasting Returns Coefficients Variable Equation Equation LR p-value ERC 2.464 (22.75) Constant 0.000 -0.028 (0.02) (-4.17) AdjCFO 0.692 0.699 0.03 0.870 (18.89) (16.46) TBESO -0.228 0.568 21.48 <.0001 (-2.03) (3.35) ACC 0.431 0.478 1.02 0.312 (8.92) (10.44) STOCK_COMP 0.662 0.148 31.58 <.0001 (8.45) (1.63) N = 4,180

43

Table 8. Mispricing tests related to the tax benefit and other variables This table presents results from estimating regressions of future returns on scaled ranked values of the tax benefit and other control variables. The initial sample includes 4,577 firm-year observations from 1998 through 2005 drawn from Capital IQ. All variables other than returns are scaled by beginning of period total assets. All variables are ranked into deciles, and scaled to range between zero and one. TBESO denotes the tax benefit from employee stock options. CFO denotes cash from operations (including the tax benefit from employee stock options). ACC denotes accruals, calculated as net income minus cash from operations. Size is computed as the market value of equity. Momentum is computed using the prior 12 month return. Requiring prior year distribution to rank all variables results in a loss of 317 observations for 1998. The column labeled large firms only includes only firms with market capitalization greater than $500M. We report t-statistics corrected for heteroscedasticity and correlation within cluster (by firm and year, see Petersen 2005) for the event time results in Panel A. We report calendar time regressions (four-factor model) in panel B. Returns are based on a theoretical hedge portfolio taking a long position in firms that fall below the median tax benefit and a short position in firms falling above the median tax benefit decile. Panel A. Cross-sectional (event-time) returns tests

Model 1 Model 2 Model 3 Model 3 –

Large Firms Only

Estimate t-stat

(p-value) Estimate t-stat

(p-value) Estimate t-stat

(p-value) Estimate t-stat

(p-value) Intercept 0.122 2.33 0.045 0.86 -0.014 -0.17 -0.18 -2.89 (0.020) (0.390) (0.863) (0.004) TBESO Rank -0.168 -1.99 -0.119 -1.73 -0.141 -1.67 -0.215 -2.48 (0.046) (0.084) (0.094) (0.013) AdjCFO Rank 0.102 1.01 0.217 2.45 (0.311) (0.014) ACC Rank 0.019 0.27 0.114 2.42 (0.787) (0.016) Book-to-Market Rank 0.105 3.25 0.132 2.76 0.161 3.83 (0.001) (0.006) (0.001) Momentum Rank 0.001 0.02 -0.002 -0.03 0.062 1.67 (0.984) (0.976) (0.095) MVE Rank -0.002 -0.06 -0.008 -0.21 0.055 0.85 (0.950) (0.837) (0.395) Adj. R-Square 0.93% 1.22% 1.47% 3.49% N=4014 N=4014 N=4014 N=2385

44

Panel B. Time Series Tests using four-factor model Estimate t-statistic p-value Intercept 0.0066 1.97 0.052 MKT -0.502 -5.41 0.001 SMB -0.167 -1.59 0.117 HML 0.979 5.01 0.001 WML 0.113 1.89 0.063 Adj. R-Square 62.19% N=84

45

Table 9. Return predictive power of the tax benefit controlling for the magnitude of option exercises. This table presents results from estimating regressions of future returns on scaled ranked values of the tax benefit, control variables, and the percentage of options exercised. All variables other than returns are scaled by beginning of period total assets. Variables are ranked into deciles, and scaled to range between zero and one. TBESO denotes the tax benefit from employee stock options. CFO denotes cash from operations (excluding the tax benefit from employee stock options). ACC denotes accruals, calculated as net income minus cash from operations. Size is computed as the market value of equity. Momentum is computed using the prior 12 month return. Option exercise is the number of options exercised during the year divided by the number of options outstanding at the beginning of the year. Variables are ranked into deciles based on prior year cutoffs and scaled to range from 0 to 1. We report robust t-statistics corrected for heteroscedasticity and correlation within cluster (by firm and year, see Petersen 2007).

Estimate t-statistic Intercept -0.245 -2.12 TBESO Rank -0.120 -2.24 AdjCFO Rank 0.220 1.92 ACC Rank 0.132 1.72 Book-to-Market Rank 0.263 2.95 Momentum Rank 0.060 1.63 MVE Rank 0.030 0.66 Option Exercise Rank -0.042 -0.81 Adj. R Square 3.44% N 2522

46

Table 10. The relation between the tax benefit from employee stock options and future earnings components This table presents results from regressing one-period-ahead ROA components on current period earnings components and the tax benefit from employee stock options. The sample includes 4,420 firm-year observations from 1998 through 2005 drawn from Capital IQ. Unless otherwise specified, the following variables are scaled by beginning of period total assets. ROA denotes net income. CFO denotes cash from operations (including the tax benefit from employee stock options). ACC denotes accruals, calculated as net income minus cash from operations. AdjCFO denotes cash from operations less the tax benefit from employee stock options. TBESO denotes the tax benefit from employee stock options. AdjACC denotes accruals plus the tax benefit from employee stock options. All variables are winsorized at the 1 percent and 99 percent levels. Model:

1t,it,i3t,i2t,i101t,i ACCTBESOAdjCFOAccruals ++ ε+β+β+β+β= . (9)

Accruals = Variable ACC(t+1) AdjACC(t+1) Intercept -0.048 -0.045 (-3.57) (-3.44) AdjCFO 0.106 0.151 (1.64) (2.21) TBESO -0.766 -0.473 (-5.48) (-3.07) ACC 0.353 0.377 (8.75) (9.80) Adj. R-square 10.60% 9.08% N 4420 4420