Accounting for Employee Stock Options

by Wayne Guay, S. P. Kothari, Richard Sloan
Accounting for Employee Stock Options
Wayne Guay, S. P. Kothari, Richard Sloan
The American Economic Review
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Accounting for Employee Stock Options

Employee stock options (ESO's) are a ubiq- uitous form of compensation in corporate America. By the late 1990's, ESO's outstanding at large corporations averaged 7 percent of total outstanding shares, with top executives holding approximately one-third of total ESO's (John Core and Guay, 2001). Empirical evidence sug- gests that firms use ESO's to align employees' and shareholders' interests, attract and retain employees, and compensate employees for their labor while simultaneously raising capital from employees (Core and Guay, 1999, 2001; Kevin

J. Murphy, 1999).

There is currently an intense debate nation- ally and internationally among standard-setters, politicians, investors, corporate executives, and academics about whether to require corpora- tions to deduct the estimated value of ESO grants as a business expense in reported income. Existing accounting standards require firms to expense most forms of pay, such as salaries, cash bonuses, and the value of stock grants, but allow firms to choose whether to expense the value of ESO grants. Until very recently, nearly all firms chose not to expense ESO's. However, firms that do not expense ESO's must publicly disclose in the financial statement footnotes what reported income would have been if the ESO's were expensed. In a recent sample of large growth firms, Christine Botosan and Marlene Plumlee (2001) find that mandatory expensing of ESO's would have resulted in a 14-percent median reduction in firms' earnings per share. Firms are also required to disclose details of top-executive ESO compensation in the annual proxy statement.

Underlying the ESO debate is the concern that the choice among alternative financial- accounting treatments have real economic con- sequences. A large literature beginning with

* Guay: Wharton School, University of Pennsylvania, Philadelphia, PA 19104; Kothari: Sloan School of Manage- ment, Massachusetts Institute of Technology, Cambridge, MA 02142; Sloan: University of Michigan ~usiness school, Ann Arbor, MI 48109-1234. We acknowledge helpful com- ments of John Core, Rich Frankel, and Joe Weber.

Ross Watts and Jerold Zirnmerman (1978) pro- vides evidence that accounting choice can im- pose economic costs on firms when contracts (e.g., debt and executive compensation con- tracts) or influential external parties (e.g., tax authorities) rely on reported accounting num- bers (see Thomas Fields et al. [2001] for a survey of this literature). Accounting choice can also have economic conseauences if investors fixate on particular numbers, such as reported earnings, resulting in security mispricing and misallocation of capital.

Proponents of mandatory expensing argue that ESO's reflect a cost of acquiring employee labor, and that expensing ESO's conveys this information to outsiders consistently with other labor costs. Some argue that the absence of ESO expense results in stock mispricings, because investors fixate on reported earnings and fail to understand or utilize supplemental footnote dis- closures about the true economic cost of ESO grants. Others argue that, when investors and boards of directors fixate on accounting earn- ings, the absence of ESO expense exacerbates ineffective corporate governance and allows management to use ESO's to extract excessive compensation. Proponents of this view argue that expensing ESO's will reign in management compensation by putting it under a brighter light.

Opponents of expensing ESO's argue that deducting the cost of ESO's from earnings con- veys an impression of weaker financial results to investors and, under the assumption that in- vestors fixate on reported earnings, could raise the firms' cost of financing and stifle corporate investment and innovation. There is also a con- cern that external parties, such as taxing author- ities, might use changes in financial-accounting treatment as a cue to alter regulatory and tax policy.

I. Accounting Issues

The ESO transaction involves the exchange of labor inputs for a contingent equity claim on


the firm, and it raises several complex account- ing issues. We consider three such issues below.

A. ESO Issuance Combines Operating and Financing Activities

Granting ESO's is economically equivalent to two separate transactions. In the first trans- action, the firm sells warrants to the employee for cash. This is a pure financing transaction, resulting in the generation of cash and an in- crease in the firm's equity capital. In the second transaction, the firm pays the cash to the em- ployee as compensation for services rendered. This is a pure operating transaction, resulting in the subsequent use of resources and a corre- sponding charge to earnings. Thus, consistent with the existing accounting for stock grants to employees, the proper accounting treatment for an ESO grant is an entry to increase contributed equity capital and an entry to deduct the value of ESO's from reported earnings.

To see this point, consider two economically equivalent firms: firm A issues common-stock warrants to investors for cash and then uses cash to pay for all production inputs; firm B uses ESO's to pay for all production inputs. Firm A computes earnings as revenue received from the sale of the inputs less the purchase price of the inputs. Assuming no expense for ESO's, firm B's earnings equal revenues. Thus, earnings are very different across the two firms, yet both firms raise the same amount of capital and gen- erate the same economic earnings.

Many prominent business leaders, such as Harvey Golub (former CEO, American Ex- press) and Andrew Grove (CEO, Intel), argue passionately against expensing ESO's. Their ar- gument is that the economic impact of ESO's manifests itself through shareholder dilution, and that the denominator in the computation of earnings per share (EPS) already adequately captures the "dilution cost" of ESO's. As a result, expensing ESO's essentially double-counts the cost of ESO's. As background, for a firm with common stock and ESO's outstand- ing, the denominator in the computation of EPS is the sum of (i) the average number of out- standing common shares and (ii) an adjustment for outstanding ESO's based on a formula that converts the number of outstanding ESO's into an "equivalent" number of common shares.

However, the above argument is flawed. It makes the mistake of confusing the financing implications of raising equity capital with the operating costs of paying for operating resources. To clarify this point, consider the fol- lowing two firms. Fh A initially holds $200 in assets funded by 20 shares of common stock issued at $10 per share. Firm A sells the assets for $220, recognizes $220 of revenue and $200 of expense. Earnings are $20, and EPS is $1 ($20120 shares), reflecting a 10-percent return on equity capital. Firm B holds $100 in assets funded by 10 shares of common stock issued at $10 per share and also grants $100 of stock to a new employee in return for labor worth $100. Firm B then sells the assets and labor for $220. If the cost of the new labor is not expensed, firm B recognizes $220 of revenues and $100 of expense. Earnings are $120, and EPS is $6 ($120/20 shares), reflecting a 60-percent return on equity capital.

Although both firms generate a 10-percent eco- nomic return on capital, firm B's EPS reflects a misleading accounting return of 60 percent on capital. Note that, because the denominator of firm B's EPS includes an adjustment for the 10 shares of stock issued to acquire labor, the prob- lem with firm B's EPS stems solely from the failure to deduct labor expense from reported earnings in the numerator. This example illus- trates the need for an EPS measure where (i) the numerator of EPS includes a deduction for ESO grants to reflect the cost of the labor resources received by the firm upon granting the option, and (ii) the denominator includes an adjustment for outstanding shares and ESO's to reflect the fact that existing shareholders and option hold- ers have an economic claim on the firm's earnings performance.' Although the above ex- ample assumes stock shares (not ESO's) are granted to acquire labor, the economic intuition is identical when ESO's are granted to acquire labor (see Dieter Hess and Erik Lueders, 2001; Core et al., 2002).

Core et al. (2002) document that, although an ESO adjustment to the denominator of EPS is indeed necessary, the current accounting rules require an adjustment that understates the economic dilution of outstanding ESO's by about 50 percent, on average.

B. ESO Grants Are a Barter Transaction

Granting ESO's is a barter transaction in- volving the exchange of labor services for a contingent equity claim. As with all barter transactions, determination of the fair value of the exchange is an accounting issue. Although option-pricing techniques (e.g., Black-Scholes) are well developed, ESO's have features, such as vesting provisions, nontransferability, and accelerated maturity when the holder terminates employment, that deviate from the assumptions underlying standard option-pricing models for publicly traded options. As a result, managers' exercise policies likely deviate from the assumptions underlying the Black-Scholes frame- work (e.g., Steven Huddart, 1994; Charles Cuny and Philippe Jorion, 1995). Reasonable solu- tions to this problem have been proposed in which ESO's are valued using the expected time until exercise (e.g., Thomas Hemmer et al., 1994).

Accounting standard-setters are often reluc- tant to recognize numbers in the financial state- ments that cannot be measured reliably (e.g., research and development expenditures are not recognized as assets because it is argued that the future benefits of these expenditures cannot be reliably estimated). Some argue that ESO's should not be expensed for this reason. Further, empirical evidence suggests that some firms use discretion in the assumptions underlying ESO valuation to manipulate ESO expense (David Aboody et al., 2002). However, we believe that ESO grant valuation is no more complicated than the estimation of many other common cor- porate expenses (e.g., the annual expense recog- nized for pensions and postretirement benefits is based on estimates of the present value of future retirement benefits earned by current employees during the year).

A related argument is that, because employ- ees are risk-averse and are not allowed to con- struct the type of risk free hedges that form the basis for option pricing models, traditional option- pricing models may overvalue ESO grants from the employee's perspective (e.g., Brian Hall and Murphy, 2002). Some firms use these argu- ments to justify either a lower option expense or to bolster the case against the reliable measure- ment of ESO value. However, regardless of employees' valuation of ESO's, it is the cost of the ESO grant to the firm's existing owners rather than the employees' valuation that mat- ters when determining the appropriate amount to expense. To illustrate, companies sometimes reward employees with fringe benefits for in- centive or reward purposes, such as first-class air tickets or country-club memberships. The fact that some employees value these perqui- sites at less than company cost does not mean that the company should expense these benefits at less than cost.

C. ESO's as a Contingent Financial
Obligation Through Time

A third issue arising in expensing ESO's is the treatment of changes in the fair value of the contingent equity claim between the grant and exercise dates. The amount of value the option holder ultimately receives depends on the exer- cise value (i.e., share price) at the exercise date. Thus, because option-holders bear risk associ- ated with changes in equity value over time, ESO's provide existing shareholders with a form of insurance against future firm performance.

An interesting accounting issue is whether the ex post realization of the risk borne by the option holders should be reflected in firm earn- ings. That is, should changes in ESO value between the grant and exercise dates be in- cluded as a component of earnings to reflect the fact that option-holders receive a portion of any change in the net asset value of the firm? Such an approach is consistent with an accounting objective where earnings appropriately reflect any change in the common stockholders' net assets (i.e., assets less liabilities).

A problem with this approach is that the change in ESO portfolio value reflects changes in the firm's stock price, and stock price reflects the capitalized change in the present value of expected firm earnings. Because accounting earnings generally do not reflect changes in the present value of most assets, marlung-to-market some components of equity, but not assets, may result in an earnings stream that hlnders market participants in assessing the amounts and risk of firms' future cash flows2

For example, consider a technology firm with substan- tial outstanding ESO's whose stock price rises substantially

11. Economic Consequences of Expensing ESO's

Accounting for ESO's is one of the most controversial accounting issues in recent his- tory. Corporate America and the major account- ing firms lobbied aggressively against the mandated expensing of stock options during the 1990's. Their efforts forced the Financial Ac- counting Standards Board (FASB) to back down and recommend, but not require, the ex- pensing of ESO's. The FASB summarizes the most commonly voiced concern with the man- datory expensing of ESO's as follows (from "FASB Preliminary Summary of Responses to Exposure Draft," issued 30 June 1993):

Respondents who objected to the pro- posed accounting on the basis of public policy concerns asserted that the recogni- tion of compensation costs for fixed stock options will result in lower stock prices and higher costs of capital and will there- fore cause many companies to eliminate or significantly curtail their stock-price based compensation programs.

Firms publicly disclose details of ESO plans in their financial statements, including the esti- mated cost of option grants and the total number of ESO's outstanding. Details about the level and composition of top executives' compensa- tion, including the estimated value of the ESO grants, are disclosed publicly in the annual proxy statement. Thus, the concern described above relies on a form of market inefficiency where marginal investors fixate on reported earnings and ignore information about business expenses not explicitly recognized in contem- poraneous earnings. Accumulated empirical re- search over the past four decades contradicts this extreme form of market inefficiency (for evidence that investors do not ignore ESO dis- closures see Aboody [I9961 and Timothy Bell et al. [2002]). Even if markets were character-

due to good news about future sales from a newly patented product. If the firm expenses the increase in ESO value that results from the increased stock price, the firm will experi- ence a sharp decline in reported earnings in a period where good news occurs. The potential informational problem here stems from the fact that reported accounting earnings in general do not capture large portions of the information reflected in current stock returns.

ized by such inefficiency, however, it would seem to strengthen the case for recognizing these very real costs in earnings.

Given these arguments, why are many firms and executives so staunchly opposed to the ex- pensing of options? Equally importantly, what would be the benefit of changing accounting to require coporations to expense ESO's?

One hypothesis for executives' opposition to expensing ESO's, is that it would influence con- tracting arrangements by making ESO compen- sation to top executives more visible. This, in turn, would make it more difficult for top exec- utives in firms characterized by poor corporate governance to justify awarding themselves ex- cessively lucrative pay packages. Contracting and transactions costs render corporate gover- nance an imperfect process, and unlike stock prices (which evidence suggests are influenced primarily by marginal investors), the effective- ness of corporate governance depends on the actions of all voting shareholders. Individual shareholders often do not have strong incentives to expend effort on governance activities, and without a transparent and potentially contract- ible number associated with ESO grants, some top executives can use ESO's to transfer wealth from shareholders. Supporting empirical evi- dence finds firms that most actively lobbied against the expensing of ESO's are character- ized by having top executives who receive a greater proportion of their compensation from options, receive higher total compensation, and use ESO's more aggressively for themselves versus other employees (Patricia Dechow et al., 1996). This hypothesis generates an empirical prediction that ESO awards, especially to top executives, will decline following the manda- tory expensing of ESO's, particularly in firms with ineffective corporate governance. Recently, many firms have voluntarily expensed the cost of ESO grants. The hypothesis also predicts that the governance of expensing firms is more effective than that of the non-ex~ensers.~

We note, however, that compensation contracts will only be written efficiently if boards and investors fully understand both the cost of ESO's and the incentive effects of options, stock, cash, and other forms of compensation. Reaching agreement about the appropriate ESO expense and conveying thls information to boards and investors is likely to be much easier than the difficult tasks of ensuring

A final possibility to explain firms' opposi- tion is that expensing ESO's imposes real eco- nomic costs on firms related to contracting or influential external parties. For example, lower publicly reported profits due to ESO expense might result in the loss of customer confidence or more binding debt covenants. Alternatively, young growth firms that rely heavily on ESO's may fear that the FASB's endorsement of ESO expense will prompt the IRS to tax ESO grants to employees as regular compensation, instead of deferring employee tax until exercise.

111. Conclusion

Corporate and political pressures should not determine ESO accounting rules. ESO's are a key component of top executive compensation that serve useful contracting functions. How- ever, the goal of accounting is not to distort financial performance to subsidize particular business activities. Accounting should reflect the true costs of doing business, and labor ac- quired through ESO grants is a real economic cost that firms should deduct from earnings as an expense. Armed with clear information on operating costs, investors, creditors, boards of directors, and regulators should be left to deter- mine business practice.


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