Does Recognition Versus Disclosure Really Matter? Evidence from the Market Valuation of Recognition of Employee Stock Option Expenses

Abstract

This paper examines the market valuation of employee stock option expenses recognized by using the fair value approach under the Canadian Institute of Chartered Accounts Handbook section (CICA HB) 3870. Based on a sample of Canadian public firms traded on the Toronto Stock Exchange (TSX), we find that investors value employee stock option expenses differently prior to and after the implementation of the new standard. Specifically, pro forma compensation expenses disclosed prior to the new accounting regulation are negatively associated with annual stock returns, suggesting that the market interprets these expenses to have negative valuation consequences. In contrast, recognized stock option expenses from using the fair value approach mandated by the HB 3870 are positively associated with stock returns, indicating that the market now interprets these expenses as a type of “asset” that contributes positively to firm valuation. Overall, the evidence suggests that the mandatory expensing of employee stock options increases the perceived quality of financial statements and mitigates the perception that firms use stock options opportunistically. Consequently, the market is able to translate the incentive effect of employee stock options into firm value.