This study empirically examines whether the credit market perceives outstanding employee stock options (ESOs) as a liability-like or equity-like obligation when assessing the credit risk of the issuing company. ESOs create a potential obligation for a company to transfer its own shares at a price lower than the prevailing market price in the future. Since this obligation is settled with equity but not the company's assets or services, ESOs do not meet the definition of liabilities under the FASB's current conceptual framework. Critics argue that the settlement of ESOs involves a sacrifice of economic benefits and propose that ESOs be accounted for as a liability. Using a sample 913 firm-years covering 338 firms for the period 2001-2003 and a sample of 309 new bonds issued by 195 firms from January 2001 to October 2004, I find that a higher value of outstanding ESOs is associated with a higher cost of debt, as proxied by the firm's credit rating and yield spread. The positive relationship between outstanding ESOs and the cost of debt is robust to controls of information risk, operating risk, various corporate governance mechanisms and known determinants of corporate credit risk. In addition, the adverse impact of outstanding ESOs on credit quality is more pronounced for firms that maintain a policy of expending cash to repurchase shares in response to ESO exercise. Overall, these results are consistent with the notion that credit market participants perceive outstanding ESOs as having a liability-like impact on the company's credit risk and thus demand a higher risk premium to compensate for the added risk associated with ESOs.
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