Abstract: We investigate the extent to which employee stock option (ESO) cutbacks around issuance of SFAS 123R are explained by eliminating the favorable accounting treatment available to firms prior to SFAS 123R and the economic consequences of such ESO cutbacks. We find a reduction in the grant day fair value of ESOs to all employees, which is an increasing function of the accounting benefits the firm derived from ESOs’ favorable accounting treatment prior to SFAS 123R. The removal of these accounting benefits explains 20% (45%) of ESO cutbacks around the issuance of SFAS 123R for our sample median (mean) firm. We do not find that firms cutting back more on the use of ESOs experienced a greater decrease in firm performance. Rather, a dollar increase in ESOs is associated with higher future productivity and higher future firm value in the post-SFAS 123R period. Collectively, our evidence suggests that ESOs’ favorable accounting treatment prior to SFAS 123R provided firms with incentives to make compensation decisions that minimized accounting expense but did not maximize firm value. We show that firms were more likely to replace ESOs with restricted stock and long-term incentive plans post-SFAS 123R but the substitution was far less than dollar for dollar.