Leveling the Executive Options Playing Field

Harvard Business School professor Mihir A. Desai recently presented testimony to a U.S. Senate subcommittee looking at the subject of executive stock options. His theme: A "dual-reporting system" makes it difficult for investors and tax authorities to learn the real numbers.
by Mihir Desai

Harvard Business School professor Mihir A. Desai argues that investors and regulators are served poorly by the U.S. corporate financial reporting system, which allows companies to declare different profit figures to the IRS than they report to shareholders.

In testimony to a U.S. Senate subcommittee delivered June 5, Desai detailed his view of this "dual-reporting system" and the implications on how executive stock options are treated.

The hearing was titled "Executive Stock Options: Should the IRS and Stockholders Be Given Different Information?" The subcommittee was examining the role of stock options in executive compensation; the incidence of stock option abuses; how stock option compensation is reported to stockholders under generally accepted accounting principles versus how the same compensation is reported to the IRS under federal tax rules; the origins, nature, and extent of the resulting book-tax difference; and the policy reasons for continuing or ending the stock option book-tax difference.

Here is Desai's summary statement to the subcommittee with a link to his full testimony.

Chairman Levin and members of the subcommittee, it is a pleasure to appear before you today to discuss the accounting and tax treatment of incentive compensation. I am an associate professor of finance at Harvard Business School and a faculty research fellow of the National Bureau of Economic Research.

“The dual-reporting system can enable opportunistic behavior by managers at the expense of investors and tax authorities.”

My comments below provide an overview of the financial and tax accounting systems and their treatment of incentive compensation. Independently, the topics of financial accounting, tax accounting, and stock options are extremely confusing. Taken together, they can be overwhelming and, frankly, mind-numbing. While my comments below are much more nuanced, I thought I would begin with a thought experiment that I've found helpful for simplifying the relevant issues.

Imagine if you were allowed to represent your income to the IRS on your 1040 in one way and on your credit application to your mortgage lender in another way. In a moment of weakness, you might account for your income favorably to your prospective lender and not so favorably to the IRS. You might find yourself coming up with all kinds of curious rationalizations for why something is an expense for the tax authorities but not an expense to the lender.

You don't have this opportunity and for good reason. Your lender can rely on the 1040 they review when deciding whether you are creditworthy because you would not overly inflate your earnings given your desire to minimize taxes. Similarly, tax authorities can rely on the use of the 1040 for other purposes to limit the degree of income understatement given your need for capital. The uniformity with which you are forced to characterize your economic situation provides a natural limit on opportunistic behavior.

While individuals are not faced with this perplexing choice of how to characterize their income depending on the audience, corporations do find themselves in this curious situation. A dual-reporting system is standard in corporate America and, judging from recent analysis, gives rise to opportunistic behavior.

Indeed, a significant cost for corporations—the cost associated with compensating key employees with stock options—was until recently treated as an expense for tax purposes but not for financial accounting purposes. More specifically, the value of stock options exercised in a given period gave rise to a taxable deduction for corporations while those stock options were never expensed for financial accounting purposes, though they were noted in other disclosures. This can be viewed as the most advantageous way to treat an expense—reducing the firm's tax liability while not detracting at all from its financial bottom line.

Recent changes in financial accounting have changed this asymmetry so that there is now an expense associated with stock options, but a considerable difference still exists with tax rules.

Specifically, the amount and timing of the deduction are distinctive. The financial accounting expense is at the time of grant, and the amount expensed is the value of the options at the time of grant (versus the value of the exercised options at the time of exercise). Grant and exercise values, as well as their timing, will differ significantly. Historically, the distinctive treatment of stock options has contributed significantly to the overall difference between financial and tax accounting reports, as shown in Desai (2003) and Boynton, DeFilippes, and Legel (2006).

Does this situation make sense? In order to consider this question, I will review the nature of the dual-reporting system in the United States, the debate over changing this system to one where conformity would be more common, the international experience with increased conformity, evidence on the behavioral consequences of stock options, and international variation on the tax treatment on stock options.

Several conclusions emerge:

1. As suggested by the example above and further elaborated on below, the dual-reporting system can enable opportunistic behavior by managers at the expense of investors and tax authorities. This insight, from an emerging body of work labeled the "corporate governance view of taxation," suggests that tax authorities can be meaningful monitors who complement the activities of shareholders concerned with opportunistic insiders. Under the current dual-reporting system, it is impossible for investors to tell what firms pay in taxes, clouding what a firm's true economic performance is. The evolution of the 2 parallel universes of financial and accounting reporting systems appears to be a historical accident rather than a manifestation of 2 competing views of what profits should be. Aligning tax definitions with financial accounting standards can have payoffs to investors and tax authorities, can lower compliance costs of the corporate tax, and can allow for a lower corporate tax rate on a wider base. Concerns over greater alignment between tax and financial accounting are important but many of these concerns are overstated, as I discuss below.

2. Changing financial accounting standards has stimulated debate worldwide on the virtues of greater conformity. Many countries, including notably the UK, have shifted toward greater alignment of tax and accounting reports with little apparent disruption. More broadly, tax authorities in many countries in the European Union explicitly reference financial accounting treatments in several parts of the tax treatment of corporations. Indeed, the European Union is contemplating yet a more aggressive alignment between tax and accounting rules. The relative segregation of financial accounting and tax treatment of corporate income appears to make the United States somewhat anomalous by international standards. By itself, this international experience is informative but hardly decisive as the United States may choose quite different rules for good reasons. Nonetheless, it is enlightening to see that increased conformity can work and need not represent a doomsday outcome as some have suggested.

3. Stock options are a critical part of our economic system today. They are extremely valuable tools that have numerous benefits and several costs. Their use is influenced by their accounting treatment and, to some degree, by their tax treatment. As such, changing the accounting and tax treatments of stock options can be expected to change their use. Existing evidence, though scant, is consistent with increased disclosure limiting the use of stock options but also with investors appreciating the disclosure and changing their valuations of firms accordingly.

4. There exists considerable variation internationally on the tax treatment of stock options. In particular, some countries, such as Canada, do not allow any tax deduction for stock options, while others take the deduction at the time of grant, and others follow the United States and provide a deduction at the time of exercise. Again, this international experience is informative but hardly conclusive as the United States may choose quite different rules given that stock option compensation is much more central to compensation in the United States than elsewhere. Nonetheless, it is enlightening to realize that there are many different ways to solve this problem and that the current situation is not a natural solution.

5. Bringing the tax treatment of stock options into alignment with the recent changes to the accounting treatment has a number of virtues. First, it would make the tax treatment consistent with the accounting profession's well-reasoned analysis of when this deduction is appropriate and what the right amount of the deduction is. Second, as with other movements toward greater alignment, reducing the reporting distinction in how managers are paid can create greater accountability and reduce distortions to the form of managerial compensation. Third, there is limited reason to believe that the purported costs typically attributed to greater alignment between tax and financial accounting would be relevant in this setting. There are a number of nontrivial complications associated with such a change. Implementing such a change will require thinking through if the timing of taxable events for individuals and corporations can be separated and if the compensation expensed by corporations and earned by individuals need be the same.

In sum, this example of increased conformity between financial and tax accounting has much to recommend it and need not be viewed as a radical departure from global practice. It will still allow for the many benefits of incentive compensation to accrue to the U.S. economy without continuing the distortions associated with the current anomalous distinction between tax and accounting reports.

Read the entire testimony.

About the Author

Mihir Desai is the MBA Class of 1961 Fellow, and an associate professor at Harvard Business School. Joshua Margolis is the Thomas S. Murphy Associate Professor of Business Administration at Harvard Business School.