16
thof June, 2014: Final version
University of Amsterdam
C. Clune
BSc Accountancy & Control
The reporting of employee stock options: Is the revision
from SFAS No. 123 to SFAS No. 123 (R) desirable?
Mark van Tol
10247130
Words: 8647
Abstract
Recent years the use of employee stock options as an incentive scheme has
increased significantly. This caused a lot of discussion about the way in which these stock options should be reported for in the financial statements of a company. In 2005 the FASB introduced a new accounting standard as an answer to all the controversy about this reporting issue. They issued SFAS No. 123 Revised, which mandated the recognition of an employee stock option expense within the income statement. But this has only led to more discussion about this topic. This paper will contribute to this discussion by reviewing the known literature written on this reporting issue. This will be done to investigate whether the revision from SFAS No. 123 to SFAS No. 123 (R) is actually an improvement and leads to more relevance and reliability within the financial statements. The method that is used to accomplish this is a literature review of the research done to this accounting treatment. The findings indicate that the recognition under the revised standard is seen as value relevant by the stockholders. Other findings indicate that the existence of managerial discretion can lead to underestimation of the expense, which has a negative effect on the relevance and reliability of the financial statements. As conclusion can be drawn that the revision leads to more reliable and relevant financial reporting.
Table of contents
1. Introduction
3
2. Background
6
2.1 What are employee stock options and why do companies use them?
6
2.2 Different accounting methods leading to SFAS No. 123(R)
9
3. Literature review
12
3.1 Reliability in financial statements: disclosure vs recognition
12
3.2 Managerial discretion and effect on expense estimates
15
3.3 Possible future improvements of current standard
19
4. Discussion and Conclusion
21
5. References
23
6. Dutch summary
25
1. Introduction
In recent decades the use of employee stock options rose significantly. According to estimates approximately 28 million people in the United States are engaged in employee stock option plans. Although these are estimates, they are more
conservative from nature, so it seems possible that even more employees participate in these plans. An overall estimate shows that almost 8 percent of company equity is in the hands of employees (ESOP, 2014). These stock options are included by employers in the contracts with their employees. The purpose of these stock options is to improve the salary without increasing the fixed payment, which makes stock options a kind of a bonus scheme. This should make a greater incentive for higher staff members to work for a particular employer and to improve their performance. These employee stock options should align the interests of shareholders and
employees because the payoff from these bonuses are related to the share price of the company. Each 1 percent change in company stock leads to an greater rise in the value of an employee stock option (Core and Guay, 1999). A study from Chourou, Abaoub and Saadi (2006) even shows that most large companies with significant growth opportunities use these kind of managerial equity incentives, mainly in the high-tech industry, which seems logical because the growth opportunities in that industry are enormous.
But after big corporate scandals in 2001 and 2002, like Enron, Worldcom and Tyco Industries, there came a big pressure on the FASB to adjust their recent policy for employee stock option reporting (Brous and Datar, 2007). Not only these scandals caused this discussion, but the financial crisis was also an important factor which increased the amount of pressure on this kind of bonuses. This was a result of the financial distress that the crisis created on the international stock markets. Off course, this brings a lot of discussion with it about the reporting of these employee stock options in the financial statements of the companies who provide these to their employees. These policy debates have led to different reporting standards issued by the authorities. Landsman, Peasnell, Pope and Yeh (2006) call this debate an long and acrimonious one, because of all the contradictory opinions. And this discussion will go on for a long time because it is hard to believe that academics and regulators, like the FASB, will agree on this in the near future.
Back in 2005 the latest adjustment to this accounting method was issued by the FASB. End of 2004 the FASB announced a new standard for employee stock option reporting, namely the SFAS No. 123(R) Share-based Payment1. This was a revision of the former standard, named SFAS No. 123 Accounting for Stock-Based
Compensation. The idea of this new standard is that companies are mandated to
recognize an expense for employee stock options in the income statement, instead of just including them in the notes to the financial statements. This standard resulted from a long effort by the FASB to respond to the requests from investors and private companies to improve the quality of the reporting for these stock options (FASB 2004). According to Michael Crooch, board member of the FASB and collaborator on this SFAS No. 123(R) project, this new standard will lead to a big increase in the quality of financial reporting. In a press release he said the following about the new accounting standard:
“Recognizing the cost of share-based payments in the financial statements improves the relevance and the reliability of that financial information and helps users of
financial information to understand better the economic transactions affecting an enterprise.” (FASB, 2004).
So, according to the FASB this revision will lead to improved quality in
reporting. This reporting quality is an important issue that should be looked at within this paper. But a lot of academics oppose this statement from the FASB board member. There are a lot of doubts about the issuance of SFAS No. 123(R). Like Sahlman (2002), who says in his paper that expensing stock options will not lead to better quality of reporting. Instead he argues that it will cause opposite effects
because expensing will only increase the distorted picture in the financial statements. Another article which questions the new reporting standard is that of Aboody, Barth and Kasznik (2006). They note in their study that firms tend to understate the stock option value estimates, which lead to an even more understated stock-based compensation expense in the income statement when an expense is recognized. Managers understate these stock options for earnings management purposes to avoid that firm value decreases by this stock option expense. But off course, there are a lot of proponents of this new standard too. Like Sacho and Wingard (2004),
1 This standard is consistent with the latest IFRS No. 2 standard, but this is not relevant within this paper.
4
who point out in their article that the company compensates employees with a
financial instrument, which meets the measurement and recognition criteria stated in the IASB framework. From that they conclude that the cost therefore should be recognized in the financial statements as an expense. And when we look at work from Niu and Xu (2009), they conclude that expenses for employee stock options are treated as intangible capital by companies and its stockholders. So, this points to the conclusion that expensing stock options has a positive effect on the perceived quality of the financial statements. They conclude from their research in Canada that the market is able to translate the monetary incentives provided by stock options into firm value. This is clearly a contribution to the proponents of the SFAS No. 123(R).
In this paper the known literature written on this subject will be examined to come to a conclusion about whether the replacement of the old SFAS No. 123 standard with the new SFAS No. 123(R) standard has a positive effect on the
reliability and relevance of financial reporting. The purpose of this literature review is to contribute to this long padded discussion about the way in which stock options should be recorded, as an expense or in the notes to the financial statements. This is a very interesting discussion because nowadays it is difficult but highly important to recruit the appropriate people and to get them motivated to reach their objectives and improve their current performance. Employee stock options are a valuable tool in this process because it could provide employees with the right incentives to do a better job, for themselves but also for the company. From the viewpoint of the stockholders employee stock options are very attractive incentive tools because both the
employee and the stockholder will benefit from an increase in share price.
One of the main findings presented in this paper is that outside stockholders view the recognition of an expense for employee stock options as value relevant because it gives a positive signal about the future prospects of the company. Other findings indicate that managers have the opportunity to alter the estimate of this expense by using their managerial discretion in the option pricing model. This leads to underestimation of the expense. This underestimation can lead to a less reliable view within the financial statements because the actual expense can be much higher than the one reported. This is off course an important issue when reviewing both standards, but the findings indicate that this underestimation of the stock option expense is less severe under mandatory recognition than under voluntary
recognition, which is allowed under SFAS No. 123. So, this is clearly an advantage for the new standard.
This paper starts in section 2 with the background of employee stock options. After that the known literature will be investigated in section 3. Followed by the
discussion and conclusion that is drawn in section 4. Lastly, section 5 consists of the references used in this paper.
2. Background
2.1 What are employee stock options and why do companies use them?
We have seen a rise in the number of companies which offer their employees stock options. But it seems desirable to give some background information about these stock options. So, first this paper will explain what employee stock options are and why companies use them as an incentive tool. This to create a better understanding of the whole phenomena.
These employee stock options can be seen as an agreement between employer and employee that gives the employee the right to buy a fixed number of shares of the particular company. These shares can be bought after a
pre-determined period, which is called the exercise period, and the shares will be bought against a specified exercise price. These employee stock options are named call options. These are not the only type of stock options, it is also possible to buy put options but these are not relevant within this paper because employee stock options are always call options. The idea behind these call options is that when the price of the particular shares rise, the employee can buy the shares at the pre-determined exercise price. So, when these exercise price is lower than the current market price of the shares, the employee can use his right to buy these shares at a price less than the market value. When this becomes reality the options are called ‘in the money’. When the employee decides to sell his stock options he can make a profit because of the gap between the market price and the exercise price at which he bought the options. This gap in prices will be the profit that the employee makes (Hall and Murphy, 2003).
But it is also possible that the market price falls below the exercise price, in this case the option is called ‘out of the money’ and the employee will make no profit on his stock option and no expense will incur for the company (Huddart, 1994). It is not possible to exercise the option before the exercise date is reached. This is not possible because the employee does not own the shares unconditionally in the period before the exercise period. This prior period is known as the vesting period. It is also not possible to trade these employee stock options on a public market.
Employees are only allowed to exercise and issue their stock options within their own company. And when an employee who owns employee stock options ends his
employment at the particular company, for example because he dies or simply quits his job, the shares are mostly forfeited because they are not tradable outside the company (Core and Guay, 1999).
To give a better impression of the payoff that can be earned through employee stock options this paper will provide a small mathematical example of how this payoff is calculated. In this example there exists an employee who is given the right to buy shares at a pre-determined exercise price of 100 dollar. At the end of the exercise period, the market value of those shares is 125 dollar. This will lead to a profit of 25 dollar when he decides to sell his shares. This is because he has the right to buy the shares at a price below the current market value of 125 dollar, namely 100 dollar. In this way the employee can make a profit of 25% on each share that he bought. This indicates the fact that the payoff for these employee stock options is determined by the current market price of the shares. So, it seems logical that this incentive scheme aligns the interests of both the employee and the shareholder, because both will benefit from an increase in share price (Yermack, 1995). That is the main reason why employee stock options initially were used to reduce the conflicts of interest between principals, the stockholders, and their agents, mainly higher staff members like CEO’s.
Hall and Murphy (2003) also indicate that employee stock options are a valuable tool because they give managers an incentive to work harder because they benefit from an increase in share price. But that is not the only reason they come up with. They also notice an advantage of employee stock options that makes them a better incentive tool than straight company shares, which are simple shares that are given by the company to employees for a short period as part of their salary. The
reason for this advantage is that straight shares provide a payoff anyway, with or without a good performance of the company. But due to the nonlinearity of the payoff, stock options do not give this certain payoff. When the exercise price is below the current market value, stock options do not have any value, but straight shares would hold their payoff, it’s only a bit smaller than first expected. This leads to the
conclusion that, from the viewpoint of the stockholders, employee stock options are a better incentive tool than straight shares. This is supported by work from Tirole
(2005) who sees this feature of employee stock options as a big reason for the increased use of these stock option incentive schemes.
At last, Arya and Mittendorf (2005) argue that employee stock options can serve as a tool to help firms gauge a manager’s skills and competences when they negotiate the pay terms in the contract of the possible future manager. In this way a firm can force the possible new manager to put his pay on the line because in the case that he wants to overstate his worth to the firm he needs to overstate the worth of the whole firm with him. This is a good indicator of how gifted a new employee is because in the case that he is not sure about his skills and abilities to meet the stated targets he won’t choose for this payment scheme. In this way granting employee stock options can be an effective tool in hiring more skilled and better motivated personnel. This feature of stock options can be seen as a kind of sorting mechanism. In addition to this conclusion from Arya and Mittendorf (2005) other work points out that the vesting period, in which it is impossible to exercise the options, creates more bonding of employees to the firm. In this way, employee stock options give a
company the possibility to bound their skilled employees for a longer time, because of the long-term incentives that result from stock options (Aboody, 1996).
So it seems that employee stock options have many benefits, but there are also some drawbacks which should be considered by a company when they decide to issue these stock options. The first drawback that should be considered is the possibility that when stock options go ‘out of the money’, employees will lose their faith in a good performance and may even leave the company. In this case a
company can alter the exercise price downward or issue new stock options, but this will lead to less effective use of the stock options. The effectiveness of stock options also diminishes when they are already deep ‘in the money’, because in that case they will not trigger any motivations by the employee because he knows that he will
make a good profit on his stock options. So these employees will be less motivated to meet their targets given by the shareholders (Hall and Murphy, 2003).
Another major drawback of employee stock options is that it could cause employees to be less risk-averse. The reason for this is the nonlinearity in the payoff from stock options. When the market share price declines below the exercise value it leads to a small loss, so employees try to maximize their profit by taking more risk than they otherwise would have done. Employees will be more willingly to engage in risky projects, hoping to get a larger payoff from their stock options (Guay, 1999).
So, we can conclude that employee stock options can be a very effective tool to motivate employees to do a better job, but as shown in this section there are a couple of drawbacks when using these stock options as an incentive tool. This includes excessive risk taking and it can lower the motivation of some employees.
2.2 Different accounting methods leading to SFAS No. 123(R)
Now this paper will discuss the various accounting methods that preceded the current SFAS No. 123(R) standard. This will be discussed through a quick review of the history towards this latest adjustment. In this way it is easier to understand the accounting treatment of employee stock options.
The first standard issued by the Accounting Principles Board (APB), the predecessor to the FASB, was the APB No. 25, Accounting for Stock Issued to
Employees. This accounting standard was issued in 1972 and the idea behind this
standard was that the value of the stock-based compensation should consist of the difference between the current market price and the option exercise price, times the number of shares outstanding. Under APB No. 25 this difference should be
recognized as compensation expense. This standard is based on the intrinsic value method, and this leads to the point that when companies issue stock options with a fixed exercise price that equals the market price at the exercise date, the intrinsic value of these stock options will be zero. In the case that these two prices are equal to each other the options are called ‘at the money’. This method motivated almost every company that used employee stock options to issue stock options with an exercise price equal to current market price, in this way they were allowed to not
recognize any compensation expense in their financial statements (Aboody et al., 2004). It gave companies the choice to ignore the stock option expense, until they were exercised (Landsman et al., 2006).
But one year later Fisher Black, Robert Merton and Myron Scholes invented a new method for valuing stock options. This method was considered very reliable and it leaded to an explosive rise in the popularity and the use of employee stock options (Bodie et al., 2003). This Black-Scholes model leaded to the conclusion that it was wrong to value stock options as a zero expense. Companies realized that employee stock options were more valuable than the intrinsic value given to it under the APB No. 25 standard. Because of this insight the successor of the APB, namely the FASB, introduced in 1993 finally a new standard. They issued a new standard, called
Exposure Draft: Accounting for Stock-Based Compensation. Under this standard
companies were required to recognize the fair value at the exercise date as an
intangible asset. These fair values were calculated using the before mentioned Black-Scholes model. This asset will be expensed through amortization over the vesting period and these asset amortizations will be recorded as employee compensation expense in the income statement of the company (Landsman et al., 2006). But this new Exposure Draft standard led to a lot of apposition because it was hard to make reliable estimates about the value of the employee stock options at the exercise date. Another critical note from the opposition of this new standard was the call from a lot of companies that employee stock options were a tool to increase the growth of a company and to contract the appropriate employees without spending any cash (Hall and Murphy, 2003). But the amortization expenses that were recognized under the Exposure Draft standard led to lower annual profits. Off course this led to a lot of opposition to this new standard.
Two years later, in 1995, the FASB issued SFAS No. 123 Accounting for
Stock-Based Compensation. This new standard required companies to disclose the
effects of the employee stock option compensation expense, which was amortized from the fair value at the exercise date, in the notes to the financial statements. But they were still allowed to recognize the amortization expense in the income
statement. But it seems logical that these two methods have very different influences on net income. Where the compensation expense can lower net income, the
disclosure in the footnotes has no effect on net income. So, companies were given
the opportunity to adjust their net income by choosing a different accounting method. This led to a lot of controversy, mainly because opponents of recognition claimed that it was not possible to make a reliable estimate about the stock-based compensation expense. These reliability concerns find their source in doubts about the applicability of the valuation models and questions about the used estimates within these models (Aboody et al., 2004).
The possibility to alter net income led to a lot of distortion within the financial statements. This distortion and the big controversy about this standard increased the calls for a new accounting standard. In 2005, after a lot of discussion, the FASB introduced a new standard, namely SFAS No. 123(R) Accounting for Stock-Based
Compensation. This revision of the former standard was also an reaction of the FASB
to the issuance of IFRS No. 2 Share Based Payment. This IFRS standard obligated companies to recognize an expense for employee stock options based on the fair value of the obligation at the exercise date. The new FASB standard was quite similar to this new IFRS standard, it also required recognition of the expense based on the fair value. In most cases this fair value is calculated by using the Black-Scholes model. This model requires some estimates about four inputs, namely the stock price volatility, the risk-free interest rate, the dividend yield and the total life of the option, which constitutes of the vesting period and the exercise period (Aboody et al., 2006). With this revision the FASB tried to reduce the distortion caused by the previous standard. Firms were no longer given the opportunity to decide between recognizing the expense and disclosing it in the footnotes. With this new standard the FASB answered to the concerns of many users regarding the previous standard, comparability and converging with international accounting methods. According to the FASB the revision improved the relevance, reliability, and comparability of
information within the financial statements and gives a better insight to stockholders. (FASB, 2004).
So, this paper has shown that the road towards SFAS No. 123(R) was full of controversy and discussion about whether to expense or disclose the costs of employee stock options. Both methods have proponents and opponents, in the next section these two sides will be reviewed to come to a conclusion about which of these two standards is desirable.
3. Literature review
3.1 Reliability in financial statements: disclosure vs recognition
In the first part of this literature review section this paper will investigate the known literature to come to a conclusion about whether the recognition requirement from SFAS No. 123(R) has a positive effect on the perceived reliability within the financial statements of a company.
This section starts with work from Aboody, Barth and Kasznik (2004), in which they investigate the voluntary recognition that was allowed under SFAS No. 123. They noticed a big increase in this recognition after the big scandals in 2002 like Enron and WorldCom. The amount of companies that switched from disclosure in the financial notes to recognition in the income statement was significantly. The major argue behind this switch were several benefits arising from recognition. These benefits outweighed the costs of recognizing the expense for those companies (Aboody et al., 2004). They argue that the recognition of an employee stock option expense leads to positive reactions of capital markets, mainly in the first few days after the announcement of the switch. This recognition of an expense can be seen as a signal that those companies have proper future prospects. This seems as a very logical conclusion because when the future of a company looks bright it has the space in its financial statements to recognize the employee stock option expense. In this way companies can give positive signals to stockholders about the current financial position.
Work from Robinson and Burton (2004) supports this conclusions about recognition of the expense. Like mentioned by Aboody et al. (2004), they also found out that there is a significantly different return on stocks in the first days after the announcement. In their article they talk about three days after the switch from disclosure to recognition. Because of this they came to the conclusion that capital markets value this decision to adopt the new accounting method as value relevant (Robinson and Burton, 2004). Another article that investigated the reaction from capital markets on the announcement to recognize the employee stock option
expense is that from Schrand (2004). This paper is another prove that the recognition can be seen as a signal to capital markets. By expensing the company signals to its stockholders that it has enough future cash flows to absorb the costs from the
expense (Schrand, 2004). When this literature about recognition of the expense is reviewed it looks remarkable that recognition of the expense leads to a positive signal to stockholders about the future of the company. When companies have enough cash and future cash flows to outweigh the expense it is even considered as value relevant to a company. This value relevance is also supported by work from Niu and Xu (2009), in which they examine the market valuation of the stock option expenses within a sample of Canadian companies by using a fair value approach. They
conclude too that the market sees voluntary disclosures as value relevant, where disclosures in the notes to the financial statements are negatively associated with company value (Niu and Xu, 2009). So, it seems logical to conclude that the market indeed sees recognition of the expense as value relevance
Not only the signal about the favourable future is a good thing. Aboody et al. (2004) also noticed a signal to the outside world that the company wants to increase the reliability and transparency within their financial statements. Recognition became a way to give a signal to that outside world that it improved the quality of its earnings management . This seems like a conclusion that makes sense because when
companies do not want to recognize the expense they do not have the proper future cash flows to outweigh the expense. This can be explained as a negative signal about the reliability of the financial statements of a company. When companies are capable of better managing their earnings it should not be a problem to recognize the employee stock option expense. But, according to Schrand (2004) this conclusion is not significantly. In rational economic sense this is no significant signal because under SFAS No. 123, which was applicable in that time, it was voluntary to disclose. So it seems possible that a lot of companies were actually able to adopt the
recognition of the employee stock option expense, but did not choose to adopt it. A possible reason for this can be the fact that no actual expense incurs until the stock options are within their exercise period.
Work from Sahlman (2002) is in a certain way consistent with this suggestion. He says that the expensing of employee stock options will not give a better and more accurate view of earnings. The recognition of the expense in the income statement will not add any information to that what is presented in the notes to the financial statements. He even says that recognition leads to a more distorted picture in the financial statements because according more information about the characteristics of
the employee stock options is included in the notes, instead of only the amount of the expense. In his opinion this leads to cheating and unethical management of earnings because expensing only a monetary amount will not provide the right performance incentives. The only way to improve the quality and the reliability of the financial statements is to disclose comprehensive information and adequately introduce internal controls (Sahlman, 2002).
This conclusions drawn by Sahlman (2002) are not supported by work from others, like the article from Bodie, Kaplan and Merton (2003). In that article they point out that it is fundamental to portray a company’s underlying economic events in the income statement or the balance sheet. Relegating an item of such major
significance as employee stock options would distort the these financial statements only more (Bodie et al., 2003). Simply recognizing the expense in the statements seems more favourable than only putting an disclosure in the notes, but the rationale behind the article from Sahlman (2002) seems reasonable. It is possible that
expensing only an amount without other information can provoke cheating and earnings management to increase the payoff from these stock options. The best option would be to give more than only an estimate of the expense but also some information about the characteristics of the particular employee stock options that are recognized in the income statement. In this way it is still possible to benefit from the signals that are sent to the outside world by adopting the recognition method, but it would increase the amount of information presented to the users of the financial statements, and with that off course also the reliability.
Yet another way to look at this topic is an article from Jiang et al. (2009), in which they look at the relation between the expertise of the management within a company and the accounting method used to either expense or disclose the stock options. They noticed a positive relation between the expertise of the management and the recognition of the expense (Jiang et al., 2009). So, from this it can be concluded that better management adopts the recognition method. Thus, if the management has a bigger expertise, recognition is adopted. This could mean that management with bigger expertise consider employee stock options as an expense.
This leads to the conclusion that expensing employee stock options is widely seen as a better way to account for these stock options. Under SFAS No. 123 (R)
this is off course required by the FASB. But this review of earlier work here shows that even under the former SFAS No. 123 standard, when it was allowed to choose between recognition of an expense in the income statement and disclosure in the notes, a lot of people assign a bigger value to the recognition method. From this we can conclude that based on these criteria SFAS No. 123(R) leads to a bigger
perception of the amount of reliability in the financial statements and more perceived transparency.
3.2 Managerial discretion and effect on expense estimates
In the second section of this literature review there will be investigated whether managerial discretion leads to an understated employee stock option expense. So, the first question asked in this section is whether or not the new SFAS No. 123 (R) induces managers to use their discretion to manage their earnings.
When companies value their employee stock options under SFAS No. 123 (R) in most cases they need to calculate their fair value using the Black-Scholes model. This model uses some estimates as inputs for the calculation of the fair value.
Namely, the needed estimates are the following: the exercise price at which the stock options can be sold at the exercise date, the current stock price assigned to company stocks on that moment, the risk-free interest rate, the expected life of the stock option which consists of the time until the options reach their exercise date, the dividend yield and off course an estimate about the expected volatility that the stock option bears with it. Some of these inputs are just straightforward and cannot be adjusted by managers, but the expected volatility estimate and the expected life time of the stock options can be subject to a lot of management discretion in estimating these inputs (Blacconiere et al., 2011).
So, the main question here is whether this managerial discretion actually exists in these input estimates and under which standard this discretion has a bigger effect. When we look at work from Aboody, Barth and Kasznik (2006), they conclude that there are two incentives for managers to use their discretion in understating the employee stock option expense. The first reason identified by them is to increase the perception of outside stockholders about the company’s financial position and
profitability. Because stockholders and other users of the financial statements see employee stock option expenses as actual expenses within the income statement,
understating this expense can really alter the perceptions of stockholders about the profitability of the company. So, it would be understandable when managers use their discretion in estimating the inputs for the pricing model to make their financial
statements look better. The second incentive that Aboody et al. (2006) identify as a reason for managers to underestimate the expense is that they want to decrease the perceived excessiveness of compensation paid to firm’s executives. They notice here that other literature indicates that managers attempt to minimize these perceptions about their compensation (Aboody et al., 2006). This seems also quite fair because managers do not want that their stockholders believe that they are compensated too much, certainly not with the use of employee stock options. From the stockholder’s viewpoint this can look like executives give themselves huge bonuses through these stock options. So, it would be understandable when these managers try to decrease the perception about the magnitude of their compensation and this can be done through the understatement of the stock option expense. In their study they conclude that this management discretion has an decreasing effect on the stock option
expense. This effect is considered bigger when companies make excessive use of employee stock options as compensation for their higher staff members. Also companies that have weak corporate governance make more favourable estimates about the expected option life, dividend yield and mainly about the stock price volatility (Aboody et al., 2006).
Thus, managers use their discretion to adjust estimates within the option pricing models and it seems that the expected volatility estimate is the input that is used in most cases to underestimate the expense. To make a better understanding of this volatility estimate this paper now will investigate work from Bartov, Mohanram and Nissim (2007). Their study investigates the determinants of the expected
volatility estimate. They focus on this one input estimate because they believe, just like Aboody et al. (2006), that this parameter is indeed the main reason for the underestimation of the stock option expense. By looking at only this estimate they have the possibility to make an in depth review of how and why management discretion within this volatility estimate is used to understate the employee stock option expense. They find out that managers use both historical and forward-looking information when they estimate the expected volatility of the stock options (Bartov et al., 2007). This is consistent with the guidance in SFAS No. 123, but this can also be
considered a threat because forward-looking information can be altered by making more favourable estimates about the future. This reasoning is indeed supported by their paper because from their findings they can conclude that managers use their discretion in an opportunistic manner to understate the disclosed volatility. In support of this interpretation they find that managerial incentives and the fact that managers have the ability to understate the expense are crucial in explaining the opportunistic estimates about the volatility (Bartov et al., 2007). This supports the work from
Aboody et al. (2006) because they both argue that these managerial incentives exists and that they play a role in the calculation of the fair value of the employee stock option expense.
Another paper that contributes to this discussion about the fair value estimate of the stock option expense within the financial statements is that from Blacconiere, Frederickson, Johnson and Lewis (2011). In their article they examine the voluntary disclosure of the expense under SFAS No. 123 that disavow the reliability of the fair value estimates. They investigate whether these so called disavowals are informative or opportunistic about the reliability of the volatility estimates used in the pricing model (Blacconiere et al., 2011). According to them companies used these
disavowals to indicate to the outside world that they have a lot of doubts about the fair value expense recognized within the financial statements. This could indicate that companies find it hard to make good estimates about the various inputs for the
pricing model. This could lead to a decrease in the relevance of the employee stock option expense and this could lower the reliability of the financial statements. And this rationale is supported by Blacconiere et al. (2011) because they argue that voluntary disclosures under SFAS No. 123 show big concerns about the reliability. This is concluded from their results that companies are most likely to disavow when the estimates used in the option pricing model are considered less reliable. So, these disavowals can be interpret as signs to the market that companies have some questions about the reliability of the volatility estimates used in the estimating the employee stock option expense. They also notice some minor evidence that is consistent with the hypotheses that disavowals are used opportunistically (Blacconiere et al., 2011).
So, from the literature that is examined in this section we can conclude that there is enough evidence that managers indeed use their discretion to underestimate
the employee stock option expense within their income statement. Mainly the volatility estimate is used to accomplish this, because this input has a significant effect on the whole fair value calculation. The main reason for this underestimation of the expense is a company’s urge to make their financial statements look better. Thus, this paper can assume that this is a plausible conclusion, but now raises the question of under which accounting standard this discretion has a bigger influence. To answer this question this paper will now examine other known literature to this question.
The starting point for this examination is the work from Choudhary (2011). He investigates the differences in reliability across recognition and disclosure regimes. He compares the fair values of employee stock option expenses based on firm-reported inputs and benchmark inputs. He finds that companies have different treatments of both recognized and disclosed expenses. Companies who voluntary recognize the expense are likely to underestimate these expenses using their management discretion. In support of the earlier mentioned work from Bartov et al. (2007) he concludes that the underestimation of the expense is accomplished by reducing the estimates of the stock price volatility, which he calls the greatest estimation latitude. This is exactly what Bartov et al. (2007) concluded, so it seems reasonable that this volatility estimate indeed is the most crucial input in the
calculation of the employee stock option fair value.
Choudhary (2011) also finds out that when he compares voluntary recognition under SFAS No. 123 and mandatory recognition under SFAS No. 123 (R), there is some evidence that the accuracy is different. It appears to him that voluntary recognition is less accurate than mandatory recognition when he compares his results based on benchmarks and firm reporting (Choudhary, 2011). This conclusion is in accordance with work from Frederickson et al. (2006), which investigates the differences in the reliability of the financial statements under both accounting methods. They also find out that voluntary disclosure leads to more bias than mandatory disclosure under SFAS No. 123(R). These findings from both papers indicate that under the new accounting standard the reliability improves because companies value their employee stock options with less bias. Under SFAS No. 123 the voluntary recognition leads to much bias in the financial statements, so this is definitely an advantage for the new standard.
Another paper that investigated the effect on the reliability of the managerial discretion in estimating employee stock option expenses it that from Johnston (2006). He investigates only the differences under voluntary recognition of the expense and disclosure in the notes, which all happens under the SFAS No. 123 standard. He hypothesized that companies under voluntary recognition would underestimate their employee stock option expense. He finds out that this hypothesis is right because his results indicate that companies which voluntary recognize the expense significantly understate their stock option expense relative to companies who disclose the expense in the notes (Johnston, 2006). This is consistent with the findings from Choudhary (2011) and Blacconiere et al.(2011). Johnston (2006) also finds out that the main input used to underestimate the expense is the stock option volatility estimate. This is yet another support for the conclusion from Bartov et al. (2007).
So, from this review on the effect of managerial discretion we can conclude that this phenomena indeed exists and that managers actually use it to
underestimate the stock option expense. It is also noticed that this is mostly done through the volatility input in the pricing model. With that in mind, it seems like this managerial discretion has the biggest effect on companies who voluntarily
recognized an expense under the SFAS No. 123 standard. According to the literature reviewed, this effect on the reliability is much less when a company adopts the new SFAS No. 123(R) standard or just discloses the expense in the notes to the financial statements.
3.3 Possible future improvements of current standard
From the first two sections it can be concluded that there is a slight majority of academics and users of the financial statements who believe that the revision from SFAS No. 123 to SFAS No. 123(R) has improved the reliability of the reporting for employee stock options. But there is still a lot of discussion about this topic because the revision is considered as better than the former standard, but it still leaves room for some improvements.
To give a best understanding of accounting for employee stock options this paper will now make a little switch from whether to report stock options as an
expense in the income statement to how should they be recorded in the statements. The first work that is considered in this section is the article from Kaplan and Palepu (2003). In their work they present a new accounting mechanism that maintains the rationale underlying stock option expensing, but they have critical notes about the errors in the pricing model and the lack of reconciliation to actual experience (Kaplan and Palepu, 2003). The mechanism that they introduce in their paper is called fair-value expensing. This method expenses the option costs at the exercise date over a whole period, in most cases over the vesting period. In this way adjustments are made and the cost estimates are reconciled with the subsequent changes in the value of the stock options. With this method the forecasting and measurement errors, that arise from understatement of the estimates used in option pricing models, are eliminated over time. The method actually involves making entries on both the asset side and the liability side of the balance sheet. The amount on the asset side is then expensed through the income statement, and the liability side is then adjusted to reflect changes in the estimated fair value of the stock options at the exercise date (Kaplan and Palepu, 2003).
This method is in accordance with the article from Landsman, Peasnell, Pope and Yeh (2006), in which they investigate which accounting method best reflects the value of the stock options. Their findings indicate that the best way to accurately reflect the economic dilution on shareholder’s equity caused by the employee stock option expense is to recognize both an asset and a liability at grant date. They find out that this is the only approach which gives a reliable reflection of all gains and losses attributable to existing shareholders. It is also the only method that does not overstate the value of current shareholder’s equity (Landsman et al., 2006).
So, it seems reasonable that recoding both an asset and a liability gives a more accurate reflection the economic events behind the stock option expense recognized in the financial statements of a company. In this way the measurement errors arising from earnings management are less severe. And in this manner the company has also the opportunity to retain and motive employees to earn a good payoff by generating additional earnings for the company.
4. Discussion and Conclusion
In this section the findings from the investigated literature will be discussed and there will be drawn a conclusion about the question whether or not the revision from SFAS No. 123 to SFAS No. 123 (R) leads to more relevant and reliable financial reporting.
The first finding presented in the literature review was based on work from Aboody et al. (2004), Robinson and Burton (2004), Schrand (2004) and Niu and Xu (2009). In their work they all came up with slightly the same conclusion, namely that the market sees the recognition of an employee stock option expense as value relevant. The reason for this is that this recognition can be seen as a sign that the company has good future prospects. This seems to me as a reasonable conclusion because when a company has proper cash flows they can absorb the extra expense recognized in the income statement. I believe that when a company simply discloses the stock option expense in the notes it could be seen as a warning, because in that case the company does not have the appropriate cash flows to recognize an
expense. This value relevance is a positive effect of recognizing an expense. So, this is considered as an advantage for the revised standard.
Other articles that support the recognition of the expense are those from Bodie et al. (2003) and Jiang et al. (2009). They conclude that recognition gives a more reliable view for the users of the financial statements outside the firm. But this conclusion is contradicted by Sahlman (2002), who says that the expense does not give more information than the disclosure in the notes. However, the literature has a slight advantage here for the revised standard when the perceived reliability is considered. Therefore I believe that the conclusion that Sahlman draws is wrong because in my opinion recognition of an expense, which has an effect on net income, gives more financial information than a simple notation of the fact that the company uses employee stock options.
Another big issue within the literature about this topic is the use of managerial discretion to manage earnings. Work from Aboody et al. (2006), Blacconiere et al. (2011) and Bartov et al. (2007) indicates that this earnings management indeed exists and that in most cases this is accomplished through underestimation of the expected volatility estimate within the option pricing model. I believe in the existence of this phenomena because it has significant effects on net income and there are
always managers who want to alter the value of the expense to make their own performance look better. Work from Choudhary (2011), Frederickson et al. (2006) and Johnston (2006) indicates that companies who voluntarily recognize the
expense, which can be done under SFAS No. 123, are more likely to underestimate the stock option expense than companies who mandatorily recognize the expense under SFAS No. 123 (R). In my opinion this conclusion is right because all the research done to this recognition indicates that this is indeed the case. So, with this in mind we can conclude that under the revised standard underestimation is less severe than under the former standard.
When all these findings are put together, we can draw the following
conclusion about the research question asked in this paper: The revision form SFAS No. 123 to SFAS No. 123 (R) indeed leads to a more reliable view in financial
reporting. From the viewpoint of outside users of the financial statements, recognition is considered as more value relevant than disclosure in the notes. And while
managers indeed use their discretion to manage earnings, it has a bigger influence under the former standard, because voluntary recognition leads to more bias within the estimation of the expense than mandatory recognition.
These findings can be considered as valuable for the research area, because for many years there is a lot of discussion between academics about this reporting issue. This paper combines mostly quantitative work from various sources to come up with a conclusion. So, the conclusion that the revision is considered as more reliable and relevant than the former SFAS No. 123 standard can be seen as a valuable addition to a long discussion.
The last section of the literature review was about possible future
improvements of this accounting standard. There are not many articles written about this. The only articles that were found are those from Kaplan and Merton (2003) and Landsman et al. (2006). They call for a method based on fair-value expensing, where both an asset and a liability are recognized to account for employee stock options. This can be a good improvement but like earlier mentioned there is little research done to this possibility. So, I believe that this would be a good topic for further research in this area of interest.
5. References
Aboody, D. (1996). Market valuation of employee stock options. Journal of
Accounting and Economics, 22(1), 357-391.
Aboody, D., Barth, M., & Kasznik, R. (2004). SFAS No. 123 Stock‐Based
Compensation Expense and Equity Market Values.The Accounting Review, 79(2), 251-275.
Aboody, D., Barth, M., & Kasznik, R. (2006). Do firms understate stock option-based compensation expense disclosed under SFAS 123? Review of Accounting
Studies,11(4), 429-461.
Arya, A., & Mittendorf, B. (2005). Offering stock options to gauge managerial talent.
Journal of Accounting and Economics, 40(1), 189-210.
Bartov, E., Mohanram, P., & Nissim, D. (2007). Managerial discretion and the
economic determinants of the disclosed volatility parameter for valuing ESOs.
Review of Accounting Studies, 12(1), 155-179.
Blacconiere, W., Frederickson, J., Johnson, M., & Lewis, M. (2011). Are voluntary disclosures that disavow the reliability of mandated fair value information informative or opportunistic? Journal of Accounting and Economics, 52(2), 235-251.
Bodie, Z., Kaplan, R., & Merton, R. (2003). For the last time: stock options are an expense. Harvard Business Review, 81(1), 63-71.
Brous, P., & Datar, V. (2007). The value of transparency: Evidence from voluntarily recognizing the expense associated with employee stock options. Business
and Society Review, 112(2), 251-269.
Choudhary, P. (2011). Evidence on differences between recognition and disclosure: A comparison of inputs to estimate fair values of employee stock options.
Journal of Accounting and Economics, 51(1), 77-94.
Chourou, L., Abaoub, E., & Saadi, S. (2006). The economic determinants of CEO stock option compensation. Journal of Multinational Financial
Management, 18, 61-77.
Core, J., & Guay, W. (1999). The use of equity grants to manage optimal equity incentive levels. Journal of Accounting and Economics, 28(2), 151-184. The National Centre for Employee Ownership. (2014). ESOP (employee stock
ownership plan) facts. Retrieved May 15, 2014 from http://www.esop.org/.
Financial Accounting Standards Board. (2004). FASB issues final statement on
accounting for share-based payment. Retrieved May 12, 2014 from http://www.fasb.org/news/nr121604_ebc.shtml.
Frederickson, J., Hodge, F., & Pratt, J. (2006). The Evolution of Stock Option Accounting: Disclosure, Voluntary Recognition, Mandated Recognition and Management Disavowals. The Accounting Review, 81(5), 1073-1093. Guay, W. (1999). The sensitivity of CEO wealth to equity-risk: An analysis of the
magnitude and determinants. Journal of Financial Economics, 53(1), 43-71. Hall, B., & Murphy, K. (2003). The Trouble with Stock Options. The Journal Of
Economic Perspectives,17(3), 49-70.
Huddart, S. (1994). Employee stock options. Journal of Accounting and Economics,
18(2), 207-231.
Jiang, L., Ferris, K., & Coffman, E. (2009). The Association Between Financially Expert Independent Directors and the Accounting for Employee Stock Options.
Research in Accounting Regulation, 21(1), 1-10.
Johnston, D. (2006). Managing Stock Option Expense: The Manipulation of Option- Pricing Model Assumptions. Contemporary Accounting Research 23(2), 395-425.
Kaplan, R., & Palepu, K. (2003). Expensing stock options: A fair-value approach.
Harvard Business Review, 81(12), 105-126.
Landsman, W., Peasnell, K., Yeh, S., & Pope, P. (2006). Which approach to
accounting for employee stock options best reflects market pricing? Review of
Accounting Studies, Vol. 11(2), pp. 203-245.
Niu, F., & Xu, B. (2009). Does recognition versus disclosure really matter? Evidence from the market valuation of recognition of employee stock option expenses.
Asia-Pacific Journal of Accounting & Economics, 16(2), 215-233.
Robinson, D., & Burton, D. (2004). Discretion in financial reporting: The voluntary adoption of fair value accounting for employee stock options. Accounting
Horizons, 18(2), 97-108.
Sacho, Z., & Wingard, H. (2004). Should employee share options be expensed in an entity’s financial statements? Meditari: Research Journal of the School of
Accounting Sciences, 12(2), 141-164.
Sahlman, W. (2002). Expensing options solves nothing. Harvard Business Review,
91- 96.
Schrand, C. (2004). Discussion of firms’ voluntary recognition of stock-based compensation expense. Journal of Accounting Research, 42(2), 151-158. Tirole, J. (2005). The Theory of Corporate Finance. New Jersey: Princeton University
press.
Yermack, D. (1995). Do Corporations Award CEO Stock Options Effectively? Journal
of Financial Economics, 39(2), 237-269.
6. Dutch summary
De afgelopen jaren is het gebruik van aandelenopties, die worden verstrekt aan eigen werknemers, sterk toegenomen. Dit heeft geleid tot een langdurige discussie over de manier waarop deze aandelenopties moeten worden gerapporteerd in de jaarverslaggeving van het verstrekkende bedrijf. In 2005 heeft de FASB een nieuwe accounting standaard uitgevaardigd als antwoord op alle discussies over dit
rapportage vraagstuk. In dat jaar vaardigde de FASB de zogenaamde SFAS No. 123 Revised standaard uit. Deze standaard vereist dat bedrijven in hun
winst-en-verliesrekening een kostenpost opnemen voor de aandelenopties vertrekt aan de werknemers. Echter, deze nieuwe standaard heeft het debat over dit probleem alleen nog maar vergroot. Dit scriptieonderzoek zal bijdragen aan deze discussie door het bestuderen van eerder gedaan wetenschappelijk onderzoek naar dit rapportage vraagstuk. Dit zal geschieden aan de hand van een literatuuronderzoek, met als hoofdvraag: Is de herziening van SFAS No. 123 naar SFAS No. 123 (R) wenselijk en leidt het tot een meer betrouwbare en relevante weergave van de economische werkelijkheid in de jaarverslaggeving? De voornaamste resultaten die naar voren komen uit het onderzoek zijn dat het opnemen van een kostenpost onder de nieuwe standaard door de aandeelhouders wordt gezien als waardevol omdat het een teken is van goede toekomstvooruitzichten. Andere resultaten wijzen uit dat managers bij het bepalen van de waarde van deze kostenpost de neiging hebben de vrijheid die zij hierin hebben te misbruiken, wat leidt tot onderwaardering van de kostenpost. Echter, dit effect is groter onder de oude standaard. De conclusie die kan worden getrokken na dit onderzoek is dat de herziening van de standaard inderdaad leidt tot een meer betrouwbaar beeld in de jaarverslaggeving.
