The Cost of Equity Implications of Accounting for Employee Stock Options

Abstract

This study examines whether the accounting treatment of employee stock options affects the cost of equity capital. Using the change in accounting imposed by SFAS 123R that required recognition of an expense for the fair value of employee stock option grants, we analyze whether the new accounting standard had an effect on the relation between the value of option grants and the cost of equity. Our analysis is motivated by theoretical models that relate the presentation of accounting information to firm value (Hirschleifer and Teoh 2003) and the effects of accounting information about expected future cash flows and the cost of capital (Lambert et al. 2007), as well as the controversial debate regarding expense recognition leading to implementation of SFAS 123R. The results show that the cost of equity was decreasing in the fair value of option grants before SFAS 123R was implemented, which is consistent with theories of limited information processing of disclosed accounting information. However, we find that once expense recognition was required, the benefit of a lower cost of equity from option grants was eliminated. We also find that the cost of equity benefits under favorable accounting treatment were greater for firms operating in new economy industries, which is consistent with the information effects from expense recognition being more significant for this set of firms.