We investigate whether Financial Accounting Standard (FAS) 123R, which requires a firm to recognize its stock-based compensation at fair value, affects the firm’s stock repurchase activity. Specifically, we examine the effect of the standard on the incentive to substitute stock repurchases for dividends. As stock-option holdings increase, firms alter their payout composition; rather than offering dividends, they increase their stock repurchases to return cash to their shareholders. Prior research also indicates that stock repurchases are used to manage earnings per share (EPS). Managers are likely concerned that FAS 123R negatively impacts earnings, as firms must now record stock-based compensation at fair value. Overall, we find that FAS 123R is associated with an increase in stock repurchases and that this effect is greater the higher the level of management stock options; the impact on dividend yields, however, is less pronounced. Our study reveals the unintended economic consequences of a change in accounting by demonstrating its effects on how firms return cash to their shareholders.
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