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Stock Option Exercises and the Quality of Operating Cash Flows

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. 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 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.

Stock Option Exercises and the Quality of Operating Cash Flows