THE EFFECTS OF FINANCIAL REPORTING AND TAX COSTS ON THE RELATIVE USE OF EMPLOYEE STOCK OPTIONS (STOCK OPTIONS)

This dissertation investigates the effects of differential financial reporting and tax costs on the relative use of employee stock options. Under current financial reporting standards, employee stock options (unlike other securities) do not require a charge against reported income. It is hypothesized that the greater the benefit to the firm of reporting higher levels of income the more the firm will rely upon stock options in managerial compensation contracts and the greater the probability that the firm will choose to issue stock options than stock appreciation rights (a similar equity security that entails an eventual charge against earnings).; Incentive stock options (ISOs) are employee stock options that receive special tax treatment that generates an individual tax benefit to stock options, while imposing a tax cost to the firm. It is hypothesized that the lower the firm's marginal tax rate, the greater the use of ISOs in compensation contracts and the greater the probability that the firm will choose to issue ISOs.; The hypotheses are tested by examining a sample of 124 firms over an 11 year test period from 1979 through 1989. The results support the financial reporting hypotheses in that firms that use income increasing accounting methods tend to issue larger amounts of employee stock options and are more likely to issue stock options without attached stock appreciation rights. On the other hand, the results on the tests of the tax hypotheses are inconclusive. Although there is some evidence of a negative relationship between the use of ISOs and the firm's marginal tax rate, the relationship does not appear to be stable over time. In addition, errors in the proper classification of stock options as ISOs and in the estimation of the firm's expected future marginal tax rate reduce the ability of the tests to detect a relationship.