Stock Option Expense Research Articles

Discussion of Firms' Voluntary Recognition of Stock‐Based Compensation Expense

More than 100 firms voluntarily elected to expense stock options primarily in the summer and fall of 2002. The study by Aboody, Barth, and Kasznik (hereafter, ABK) examines the determinants of the election decision and the market reactions to these elections. Before discussing the study, it is important to note other actions that were concurrent with the decisions to expense and that had an impact on the corporate climate in the U.S. at the time of the elections (see table 1). Table 1 reveals several important patterns. First, actions by Congress and the International Accounting Standards Board (IASB) may have led firms to believe that expensing would become mandatory. The ABK study generally treats the election to expense options as a voluntary accounting change. It may be more akin to early adoption of a mandatory change, even for firms that the study defines as early announcers (announced beforeJuly 31, 2002). Second, the Sarbanes-Oxley Act, the NASDAQ and New York Stock Exchange (NYSE) rules, the financial statement certification requirements, and the Conference Board actions are all responses to increasing demands for improved corporate governance. Excessive compensation was in the limelight.

The Evolution of Stock Option Accounting: Disclosure, Voluntary Recognition, Mandated Recognition, and Management Disavowals

In this study we report the results of an experiment that examines how relatively sophisticated financial statement users interpret management stock option compensation disclosures under SFAS No. 123 and SFAS No. 123R. We predict and find that mandated income statement recognition, as required under SFAS No. 123R, leads to higher user assessments of reliability than either voluntary income statement recognition or voluntary footnote disclosure, options allowed under SFAS No. 123. Users view voluntary footnote disclosure as the least reliable reporting alternative. We also examine the amount users invest in response to these accounting treatments, and find that users invest more in a firm when management chooses income statement recognition than when management chooses footnote disclosure. We find no difference in investment amounts between mandated recognition and either voluntary recognition or footnote disclosure. Finally, although we find that these results are insensitive to whether management explicitly disavows the reliability of stock option expense, we present evidence that, in side-by-side comparisons, where one firm disavows and the other does not, disavowals may affect user judgments and decisions.

Expensing Stock Options: The Role of Publicity

In this paper we offer explanations for why firms began voluntarily adopting the expensing provisions of FAS 123 in the second half of 2002. First, we find that firms with greater publicity exposure are more likely to voluntarily expense stock options, controlling for other factors such as the magnitude of the stock option expense. This publicity incentive also explains the timing of the decisions, the summer of 2002, immediately following the accounting scandals of Enron and WorldCom. Second, we find that valuation benefits from expensing stock options, proxied by market's reaction to the proposition by the FASB to undertake a project requiring firms' to expense stock options, are positively associated with the decision to expense. Third, we do not find evidence that stronger corporate governance is associated with the likelihood to expense options. Finally, we find some evidence suggesting that, compared to control firms, expensing firms reduce the number of options granted in 2002 and have started to make more changes to their compensation plans as reflected in the most recent proxy statements.

Equity Compensation Alternatives

In 2004, the Financial Accounting Standards Board (FASB) will, most likely, announce that companies should expense stock options. In this article, an assumption is made that FASB will make this announcement. Between now and then, however, companies have a golden opportunity to reexamine the future of, and alternatives to, their equity distribution instruments. Companies have the choice of altering their existing stock option plans, or they can implement new types of plans to best meet its corporate objectives. For example, a company may choose to modify their existing plans, or a company may elect to adopt new types of plans, such as stock appreciation rights, employee stock purchase plans, restricted stock or performance-based shares. This is an excellent time for companies to reconsider their compensation plans, and just as each business is unique, so are these compensation alternatives. This article provides a snapshot into the controversy and directs companies to consider the available alternatives.

Quality of Earnings: Avoiding the Accounting Landmines

Recent corporate controversies have highlighted the link between accounting practices and varying levels of earnings quality. Earnings quality is critical to the valuation of a company, but in the absence of financial transparency, analysts must examine financial statements to find the truth about a company's quality of earnings. To avoid serious valuation errors, analysts need to dodge the accounting landmines buried in the areas of pension cost, employee stock option expense, and revenue recognition.

The Cost of Employee Stock Options

Employee stock options (ESOs) are nontransferable and employees are generally not well diversified compared to outside shareholders. These features of ESOs imply that employee option holders may optimally exercise their options significantly early relative to what would be expected for ordinary tradable options. Consequently, accounting for the cost of granting ESOs requires understanding how long employees hold the options. We use a unique database on observed option exercise patterns to document important characteristics of exercise behavior and how early exercise affects the cost of granting ESOs. We find that employees exercise their options nearly five years prior to expiration, and that there is significant predictable cross-sectional variation in exercise behavior. For example, employees in high volatility firms exercise their options more than a year and a half earlier compared to employees in firms with low volatility. We calibrate a utility-based model of option valuation to match the observed exercise behavior, and use the model to generate estimates of the cost of granting ESOs. Our estimates indicate that the cost of the option to the firm is significantly below the value of a tradable American option with a fixed 10-year (or 7-year) expiration. Importantly, we also find the bias is not uniform. Option values computed from the American valuation model with a fixed expiration overestimate the cost of ESOs more in high volatility firms compared to low volatility firms. In addition, adjusting the expiration to reflect the expected life of the option, as recommended by the FASB, still produces systematic biases in the option valuations. The FASB adjustment overstates the cost of granting ESOs in high volatility firms and understates the costs for low volatility firms, which is perhaps one reason that many technology-oriented companies (which are likely associated with high stock-price volatility) have been the most vocal in opposing the expensing of stock options. Our research suggests that modeling the exercise behavior of employees who hold stock options and how exercise patterns vary based on different firm and individual characteristics is important in understanding and accounting for the costs of granting stock-based compensation to employees.

Employee Stock Options, Residual Income Valuation and Stock Price Reaction to SFAS 123 Footnote Disclosures

This study provides a theoretical analysis and empirical investigation of the valuation implications of employee stock options. I extend the residual income model to incorporate the effects of employee stock options, and then empirically test the model using data related to employee stock options collected from companies' financial statements. I show that the value obtained from the traditional residual income model based on reported earnings must be adjusted for the value of outstanding options and expected stock option expense. The empirical results are consistent with the model, indicating the existence of a cross-sectional negative association between share prices and both outstanding employee stock options and expected stock option expense. In addition, I examine the market's response to the disclosures of stock option information around firms' 10-K filings with the SEC. I find that SFAS 123 footnote disclosures at 10-K filings communicate useful information about employee stock options to investors.

Managing Pro Forma Stock Option Expense under SFAS No. 123

We investigate whether footnote disclosures under Statement of Financial Accounting Standards (SFAS) No. 123 are managed in 1996, the first year that the disclosure was required. The 1996 phase-in of SFAS No. 123 provided firms with a unique opportunity to manipulate the pro forma disclosure in the initial years. SFAS No. 123 allows firms discretion in estimating the value of their stock option grants and in allocating that value across accounting periods. Although we find little evidence that firms manage the estimated value of their option grants, we find that firm-specific incentives affect how that value is allocated. Specifically, firms that provide high levels of either CEO compensation or stock option compensation relative to performance allocate a smaller proportion of the options' value to the 1996 pro forma expense, apparently to reduce criticism of that compensation. Small firms and firms that recently went public also allocate a smaller proportion of option value to the 1996 pro forma expense, apparently to increase perceptions of their profitability. We conjecture that firms were less likely to manage the value of the options granted than the allocation of that value in 1996 because the parameter estimates underlying the reported option value must be disclosed in the footnote, whereas the inputs to the allocation computation are not disclosed. These results, which suggest that firms manipulated pro forma stock option expense when their estimate choices cannot be observed, have implications for both standard setters and financial statement users. In particular, the FASB's current deliberations on the transition from footnote disclosure to income statement recognition for stock options should consider additional disclosures to minimize unobservable choices. More generally, the FASB may reduce potential manipulation by requiring expanded disclosures about the choices used in computing both pro forma and reported numbers.

Accounting for Executive Stock Options: A Case Study in Avoiding Tough Decisions

We review the development of accounting requirements for executive stock options (ESOs) and find that the standard‐setting process has been susceptible to pressure groups including the corporate sector, politicians and even the accounting profession itself. The failure of Australian and overseas accounting regulators to take tough decisions may have created a systematic bias towards the use of ESOs which can result in grossly inefficient compensation structures motivated by a desire to maximise reported profits rather than to create optimal managerial incentives. We conclude that most of the arguments against recognition of stock option expense can be dismissed as blatant self‐interest at worst, or remarkably muddled thinking at best.

Stock Option Expense: The Sword of Damocles Revealed

Statement of Financial Accounting Standards (SFAS) No. 123 is one of the most controversial accounting standards ever issued by the Financial Accounting Standards Board (FASB 1995) (SFAS No. 123, para. 376). More than five years have passed since SFAS No. 123 first required firms to either recognize or disclose stock option expense based on the fair value of options granted. In light of the fractious debate surrounding its passage and ongoing differences of opinion regarding the usefulness of stock option expense data, this paper reports how the standard impacts firm performance. This study examines the effect of stock option expense on the diluted earnings per share and return on assets of 100 firms identified by Fortune magazine as “America's Fastest-Growing Companies.” We find that stock option expense has a material impact on the performance measures for a majority of our sample firms. Moreover, our analysis predicts stock option expense will grow over the next several years, potentially doubling in magnitude during that time. We also document some noncompliance with the disclosure requirements of SFAS No. 123, finding that 12 percent of the sample firms provided incomplete information during the most recent year examined.

The Value-Relevance of Stock-Based Employee Compensation Disclosures

This study employs pro-forma company footnote disclosures to assess the value-relevance of employee stock option compensation expense using the fair value method as stipulated by Statement of Financial Accounting Standard No. 123. The study is motivated by the controversy surrounding the issue of accounting for employee stock options and the countervailing effects of issuing stock options on firm value. Although accounting regulators and the business community agree that employee stock options have value and therefore, are a form of compensation, critics of the FASB's proposed fair value method of accounting for employee stock options argue that measuring the compensation expense using contemporary models will result in unreliable and meaningless measures. Moreover, the expected future benefits from granting stock options suggest that this form of employee compensation is not a typical expense. We find a significant association between the disclosed compensation expense using the fair value method and firm value that is in the opposite direction from other income statement expenses. This result implies that the disclosed employee stock option expense is a value-relevant measure and the incentives derived from employee stock option plans provide value-increasing benefits to the firm. In addition, we find the positive association between the employee stock option expense and firm value is greater for firms with more growth opportunities.