Date of Graduation

8-2013

Document Type

Dissertation

Degree Name

Doctor of Philosophy in Business Administration (PhD)

Degree Level

Graduate

Department

Accounting

Advisor

Linda A. Myers

Committee Member

James N. Myers

Second Committee Member

Juan M. Sanchez

Third Committee Member

Timothy Yeager

Abstract

The term "cheap stock" describes undervalued stock options granted to CEOs and other key employees prior to initial public offerings (IPOs). Pre-IPO firms have incentives to issue cheap stock as compensation because it results in lower compensation expense on the income statement and in large cash windfalls to CEOs subsequent to the IPO. Because cheap stock results in an overstatement of earnings, the Securities and Exchange Commission frequently challenges the valuations of these grants, which makes cheap stock a key accounting issue in many IPOs. Using a sample of firms that completed IPOs between 2004 and 2007, I investigate the effect of corporate governance structures, outside monitors, and other factors on the level of cheap stock grants. My results suggest that higher-quality governance structures, specifically audit committee accounting experts and more independent boards, constrain the level of cheap stock granted to CEOs. I also find that when CEOs have a stronger intrinsic commitment to the firm and when firms receive independent stock valuations on option grant dates, CEOs receive lower levels of cheap stock. Greater levels of cheap stock are granted when directors receive pre-IPO stock options and when CEOs are hired in the two-year period before the IPO. Additionally, I find a negative relation between CEO cheap stock and future firm operating and stock return performance. Overall, my results illustrate the importance of corporate governance structures in IPO firms and suggest that greater levels of cheap stock are an indication of agency problems, which in turn, adversely affect shareholder value.

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