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An Analysis and Value Relevance of Stock-Based Compensation Costs
Steven Balsam
Temple University, Philadelphia, U.S.A.
Accounting Department, School of Business & Management,
Temple University, Philadelphia, PA 19122.
Phone: 215-204-5574; Fax: 215-204-5587
Mine H. Aksu
Koc University, Istanbul, Turkey
Rumeli Feneri Yolu, 80910 Sariyer
Istanbul, Turkey
Phone: +90-212-338-1672; Fax: +90-212-338-1653
June 2003
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An Analysis and Value Relevance of Employer�s Stock -Based
Compensation Costs
ABSTRACT
This study examines the financial reporting of employee stock options (ESOs) in the U.S. under the
current generally accepted accounting standards (GAAP) that was promulgated in 1995 and evaluates the
relevance and reliability of the disclosed and other alternative ESO costs in terms of the employer firm's market
value.
Using 10-K annual reports filed with SEC for 177 firms with ESO plans for the year 1996, the
first year SFAS No. 123: Accounting for Stock-based Compensation became effective, we first examine
the footnote disclosure requirements of SFAS No. 123. We document the reporting choice made by the
firms under the new rule, the magnitude of the fair value of the ESOs reported by the firm as a proforma
adjustment to net income and the firm-specific assumptions used in estimating the fair value. We find that
the disclosed fair value calculated by the firm is a significant amount even in 1996 even though the
statement did not apply to ESOs granted prior to 1995 and hence the disclosed fair value was an
understated estimate of the true cost.
Many authors argue that both the intrinsic value method used prior to 1996 and the current
recommended option- pricing approach to accounting for employee stock options are inadequate and would
misstate the true cost of ESOs to the firm (Balsam, 1994, Rubinstein, 1995). Hence, we next estimate
three other alternative measures of the compensation cost and use a longer time period to pick up the effect
of all outstanding stock options. One of our estimates is based on the mark-to-market rule used in valuing
Stock Appreciation Right (SAR) type of executive compensation . The second one is based on the
opportunity cost of selling the shares at exercise price rather than at market price and considers the cost to
the company of buying back treasury stock shares to be reissued to executives upon exercise of their
options. The last estimate is based on the tax benefit allowed the firm upon exercise of the options. We also
extrapolate the grant date ESO fair values, computed under a uniform option pricing model and uniform
assumptions, reported in the Execucomp database of the Compustat tape.
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Finally, we use a valuation model based on Ohlson (1995) to evaluate the comparative value
relevance of the company disclosed cost and our various estimates of the true cost. The results indicate
that: (1) with the exception of two firms, all firms have elected the disclosure alternative, thereby
continuing to avoid recognizing any expense for most of their ESOs; (2) the amounts disclosed as
compensation cost are inadequate when compared to the estimates of the true compensation cost to the
firm; (3) the amounts involved are material in relation to the net income reported by the firm; (4) the
accounting book values and net incomes of these option granting firms would not be as value relevant as
the reported bottom lines had these costs been recognized as expense in the income statement, i.e., the cost
estimates have significant valuation coefficients; and (5)our estimates of the ESO cost explain market value
better and hence they must be more value relevant for financial statement users and measured with higher
reliability. An unexpected result is that the market assesses these ESO fair values not as costs but as value
enhancing incentives to managers.
3
Introduction and Motivation
There has been a lot of controversy about the valuation and accounting recognition of ESOs.
Furthermore, their share in total compensation package of the employees has been on the rise, especially in
the �90s.1 Core and Guay (2000) find that the Black- Scholes value of ESOs granted to employees is on
average about 4% of the market capitalization in large corporations. Since these options have value, they
are costly to the employer. A direct cost is that the grant usually requires the repurchase of the firm's shares
in the open market at hefty prices to later reissue these shares to the executives upon exercise at much
lower strike prices. Furthermore, they have a dilutive effect on the existing shares of the company. Indeed,
Aboody (1996) finds a significantly negative association between his ESO estimate based on a modified
option pricing model and employer firm's share prices indicating that the market perceives ESOs to be
costly to the company. Similarly, Core, Guay and Kothari (1999) find that market value reflects potential
dilutive effect of stock options.
On the other hand, compensation through options is expected to motivate the executive to work
harder to improve future performance and maximize shareholders' value. Indeed an important rational cited
for using options on the equity of the company to compensate executives has been its role in mitigating the
shareholder-manager agency problems. Options have been shown to have a role in moderating the inherent
risk-averse investment behaviour of the managers and hence better align their interests with those of the
shareholders (e.g., Haugen and Senbet, 1981; Smith and Watts, 1992; Guay, 1999). In this respect, an
ESO may not be perceived as a regular expense of the company and thus could have a positive association
with firm value. Indeed, Dechow, Hutton, and Sloan (1996) did not find a market reaction to news about
the Exposure Draft proposed by the Financial Accounting Standards Board (FASB) that suggested
expensing of stock option costs. Rees and Scott (1998) find a positive association between the disclosed
ESO expense based on the fair value of the options granted to employees and annual stock returns. Hence,
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stock options are expected to be informative to market participants and the effect on share prices would
depend on whether the costs to the company outweigh the incentive benefits.
The objective of this study is threefold. First, it analyzes the actual ESO information
recognized/disclosed in the financial statements and the 10-K reports filed with SEC under the current
generally accepted accounting principle (GAAP) on executive stock options, SFAS No. 123. Second, it
examines the adequacy of ESO costs disclosed in terms of reflecting the true cost to the company or the
true value of the benefits derived from the services of the employees vis a vis alternative ESO cost
estimates. Specifically, we compare the fair value cost computed by the firm, using any option pricing
model they want, and disclosed in the footnotes to financial statements under SFAS No. 123, i.e., the
proforma adjustment to net income, with the following alternative proxies: i)an estimate based on
opportunity cost of granting the option, i.e., the cash flow differential between the cash outlay for share
repurchases which are then given employees upon exercise of their options and the cash inflow from the
exercise, ii) an option value estimated by using a uniform Black-Scholes option pricing model and
uniform assumptions for all firms , obtained from the Compustat-ExecuComp database, iii) a mark-to-
market cost estimate currently used for calculating compensation expense for stock appreciation rights
(SARs)2, suggested and shown to be equivalent to stock based compensation in Balsam (1994), and iv) a
cost estimate based on the tax benefit allowed the firm by IRS upon exercise of the options.
Finally, a valuation model conditional on book values and earnings (Ohlson, 1995) is used to
evaluate the value-relevance of the reported bottom lines of ESO granting firms, the fair value cost
disclosure mandated by the SFAS No. 123, and our alternative ESO cost estimates. SFAS No. 123 led to
the public disclosure of considerable ESO related proprietary information in financial statements. We
assume that market efficiently and rationally prices the firms with ESO plans and test whether the new
disclosures and other alternative cost estimates reflect the information in prices. Since the relevance of the
cost or revenue item in question and how reliably it is measured affect how well bottom lines of financial
5
statements reflect information about firm value, we expect a stronger relation between value of the firm and
the most informative ESO cost estimate. The findings indicate that (1) firms are electing the disclosure
alternative, thereby continuing to avoid recognizing expense for most of their ESOs, (2) the amounts
disclosed as compensation cost are inadequate when compared to the estimates of the true compensation
cost, (3) the amounts involved are material when compared with net income, and (4) the ESO cost
estimates are value relevant., and (5) In general, ESO costs are not perceived as regular expenses of the
company; that is, the incentive effects of ESOs seem to dominate its costs to the company.
Overall, the study is designed to shed light on a timely and controversial financial reporting issue
from a valuation perspective. It will provide feedback to the Financial Accounting Standards Board for its
controversial rule on stock options and will provide insight to the International Accounting Standards
Board (IASB) in its current deliberations at the wake of setting the international accounting standard for
ESOs.3
Accounting for ESOs and Value Relevance of Accounting Information
Current generally accepted accounting principle (GAAP) related to reporting of ESO transactions
is the Financial Accounting Standards Board (FASB) Statement No. 123, promulgated in 1995. It required
footnote disclosure of the cost of stock-based compensation, based on the fair value of the options granted,
but strongly urged firms to recognize that cost on the income statement. Thus while Statement No. 123
introduces the fair value method to accounting for ESO costs, it allows companies to continue using
Accounting Principles Board (APB) Opinion No. 25, the previous reporting rule on ESOs, for actual
income statement recognition. The cost under APB No. 25 is the intrinsic value at the measurement date
which, for a fixed ESO, is the date of grant. Since the vast majority of ESOs are normally issued with
exercise price equal to or greater than the market price at the date of grant, their intrinsic value is zero and
thus no cost is ever recognized for them.4
The intent of the FASB in promulgating Statement No. 123 was to get firms to recognize a cost for
these ESOs. That is why it has been one of the most controversial pronouncements issued by the FASB.5
6
In 1984 the FASB decided that options were a cost to the firm and that this cost should be recognized in the
financial statements (F/S). In 1993 it issued an exposure draft (Financial Accounting Standards Board
1993) that would have required firms to recognize the fair value of ESOs in their financial statements,
where the fair value of the ESOs would be calculated at the grant date using an option valuation model. In
response to unprecedented opposition, especially by small technology firms that could employ and retain
the best executives only by offering them equity ownership, FASB compromised by making recognition
voluntary, but mandating disclosure of the fair value of ESOs. The disclosure requirements include a pro
forma net income and earnings per share numbers as if the fair value of the options granted had been
recognized in the income statement as an expense. While making recognition voluntary, the FASB in
Statement No. 123 emphasized their belief that recognition was the proper accounting treatment, and urged
companies to recognize the cost.
Given semi-strong-form market efficiency, in theory, there should be no difference in the
informativeness of recognized versus disclosed information. Regulators and academicians, likewise,
believe that market participants value substance over form and, hence, where the information is presented
would not matter. However, there is also evidence that the way the information is presented in the F/S
matters, depending on who the users are and how naively they interpret footnote disclosures (Imhoff et al.,
1993, 1995). Bernard and Schipper (1994) report that while managers react to the recognition of the fair
value of stock options as expense, they do not object to its disclosure in the footnotes. They argue that the
"substance over form" argument may not work if some market participants view footnote disclosures as
being less reliable or are not sophisticated enough to make appropriate adjustments to them or if they
believe that the adjustment costs do not justify the benefits.�6 Accordingly, they predict that investors will
assign more importance to recognized F/S items and this will manifest itself in greater value-relevance.
Johnson (1992) suggests that academic research could aid in identifying how users process disclosures and
whether they are appropriate substitutes for recognition. Hence, further research on: i) the economic
effects of ESO grants and exercises on the value of the firm, ii) how the ESO grants, exercises and the
related disclosure mendated by the new rule effect the valuation multiples of reported earnings and book
values, and iii) the value-relevance of the disclosed ESO costs and benefits under SFAS 123 is necessary
to provide feedback to the FASB about the valuation impact of this controversial new standard and to
7
provide insight to the current deliberations of the IASB. Even though standard setting is mainly considered
to be a social choice problem and there is no consensus that consequences and value-relevance can be used
as objective metrics to determine preferability of one standard over another (Schipper, 1994), this paper
attempts to provide input to regulators on ESO cost recognition and measurement issues.
Sample Selection
Compustat was searched for firms meeting the following criteria for the years 1996-1998:
� Stock Option Plans, as evidenced by having Shares Reserved for the Issuance of ESOs
(Compustat data item 215),7 and actually having a footnote on ESO plans in their 10-K reports.
� December 31 fiscal year ends 8
� Filed a 10_K report with the SEC and included in Edgar data-base of SEC on the internet,
� Actually granting ESOs in either 1995 or 1996 and were thus affected by the requirements of
Statement No. 123,
� Has price data either in Compustat or on Simplystocks financial database on the internet.
yielding a final sample of 96 firms (288 firm-years).9
The financial statement data on options are obtained from the statement of changes in stockholders
equity and the footnotes on stock options in the 10-K annual reports published in the EDGAR database on
the internet. The price data and basic financial statement variables are obtained from Compustat tapes
through the WRDS interface. The Black-Scholes value ofoptions (the compustat variable BLK_VALU) are
obtained from the Execucomp database of the Compustat which contains data on option grants to key
executives (at most 5) for the S&P firms. We extrapolate the Black-Scholes value of the options granted to
executives to the options granted to all the employees in a given year by using the variable Percent-Total
(the percentage of options granted to the executive to the total of options granted to all employees).
Methodology:
EBO Models of Valuation and valuation effects of ESO cost:
8
Assuming the clean-surplus relation, Ohlson (1991, 1995) replace the future dividends in the basic
cash-flow valuation model with expected earnings and book values. They posit that the accounting bottom
line numbers of earnings and book value of equity inform us about firm value because they both help in
forecasting future expected earnings. Accordingly, He models firm value as a function of current book
value, expected abnormal earnings in excess of a normal return on book value and other orthogonal value
relevant non-accounting information. In this formulation, one can consider the cost/benefit of ESO grants
to be a value relevant financial event that is yet to impact the F/Ss and hence price through future abnormal
earnings. We assume that as the ESOs are granted to employees, as they vest, and as they are exercised, the
related ESO cost and the incentive effects are priced in an efficient market.
In an empirical application, Ohlson and Penman (1992) use disaggregated income statement and
balance sheet data as explanatory variables to explain returns. As expected, they find that the regressors
"liabilities" and "preferred stock" and have significant negative coefficient estimates while "assets" have
positive coefficient estimates. They also find that returns are positively (negatively) affected by "gains",
including other and extraordinary gains (losses). Accordingly, to the extent that the incentive benefits
provided by option based compensation plans don't dominate prices, we hypothesize that the disclosed ESO
costs and oher estimates of the cost should have a negative impact on the value of the firm. Furthermore, to
the extent these effects are not fully recognized in a timely fashion in the F/S, we hypothesize a reduction in
the value-relevance of the F/S numbers.
The few prior studies that examined the association between firm value and ESO costs have either
used an EBO model that include both book values and net income (Aboody, 1996) or the conventional
earnings capitalization model (Rees and Scott, 1998).10 Aboody study uses a modified option-pricing model
while Rees and Scott use the proforma adjustment to net income disclosed in the inancial statements as
their estimates of ESO valu. The former paper uses pre-SFAS No. 123 data to determine how investors
values ESOs prior to SFAS No. 123 while Rees and Scott used data from 1996, the first year the footnote
9
disclosure of ESO fair value was required. Hence using different models, different estimates and different
time periods, these two studies have respectively found a negative and positive relation between firm value
and ESO cost. Accordingly, whether the disclosed or estimated ESO costs are assessed as regular expenses
is a research question that has not been clearly answered yet. The accounting valuation tests employed here
are based on the EBO model and its empirical applications that suggest both reported income and book
value are priced (Ohlson and Penman, 1992; Ohlson, 1995; Penman, 1997; Collins et al., 1997). Another
reason for our focus on both earnings and BVE is that both executive stock options and SARs affect both
earnings (through either a recognized or disclosed compensation cost) and BVE (through the recognition of
a liability for SARs and equity for ESOs). We also hope that using this model will help in reconciling the
conflicting results of the abovementioned two studies. We also use a longer time period which allows the
assimilation of the newly disclosed proprietary option related information to be fully learned and assessed
by market participants. Furthermore, we use several different estimates of the true ESO cost, some
disclosed in the financial statements in accordance with GAAP, some computed by financial databases
available to only a few market participants, and some estimated by us using publicly available information.
We expect that the prices (the left-hand-side of the valuation equation) reflect the anticipated future cash
outflow due to repurchase of treasury stock for ESOs and the opportunity cost of issuing shares at option
price rather than at market price for options exercised and the potential dilution when the options are
exercised or the cash payment to executives upon exercise of SARs. However, the current accounting
standard does not allow the recognition of ESO cost and the related future increase in liability/equity
whereas the expense for SARs are recognized in the F/Ss using mark-to-market accounting. To the extent
that current reported book values and earnings (the right-hand-side) are not informative of such anticipated
costs to the company (net of potential incentive benefits), we expect the valuation coefficients of earnings
and BVE to be lower. We are also interested in how the value-relevance of selling and administrative
expenses and net income and our ESO estimates changes over the life of the option as the variables that
10
affect the value of the option changes and as ESO related assumptions and other information are disclosed
in the F/S.
Empirical Findings
Firm Choice to Disclose or Recognize:
Despite the urgings within Statement No. 123, all firms in the 1996 sample, the first year the rule
became effective, elected to disclose the cost. Disclosers include two firms with higher pro forma income.11
Thus companies continue to avoid recognition of expense for their fixed ESOs when the ESO is granted at
or above the market price at the grant date.12
ESO Information Disclosed in F/S:
Statement No. 123 required significant proprietary disclosures including:
� Pro forma net income and earnings per share as if the fair value based method of accounting were
applied.
� Weighted-average grant-date fair value of options granted during the year.
� Description of the method and significant assumptions used to estimate the fair values of options,
including: (1) risk-free rate, (2) expected life of option, (3) expected volatility, and (4) expected
dividends.
Table 1 provides descriptive statistics on the cost disclosed, both in dollar terms and as a
percentage of income. 144 firms either disclose a positive cost or pro forma income less than reported net
income, two firms report pro forma income in excess of reported net income, and 31 firms report that the
effect is immaterial.13 The dollar amounts range from ($1,722,000) to $142,000,000, with a mean of
$2,830,298 and a median of $394,487.14 As a percent of income available to common shareholders the
amounts range from (19) percent to 312 %, with a mean of 11.92 percent and a median of 3.37 %.15
Also shown in Table 1 are descriptive statistics on the assumptions used in the option pricing
model the company used to determine the fair value of the options granted, also required to be disclosed,
i.e., the risk-free rate of interest, expected life of the option, volatility rate, and expected dividends. As can
11
be seen from the table, there is quite a divergence in the assumptions used in valuing ESOs.16 The risk-free
rate of interest ranges from a minimum of 4.5 percent to a maximum of 8.5 percent, with a mean of 6.188
percent and a median of 6.25 percent. The expected life of the option ranges from a minimum of one year
to a maximum of ten years, with a mean of 5.856 years and a median of five years. Expected volatility of
stock returns ranges from a minimum of 12.9 percent to a maximum of 235 percent, with a mean of 53.345
percent and a median of 45 percent. Expected dividend yield ranges from a minimum of zero to a
maximum of twelve percent, with a mean of 0.913 percent and a median of zero. This variance across
companies does not necessarily signify companies are providing incorrect estimates.17 However, since
SFAS No. 123 leaves lots of room for interpretation due to allowing different valuation models and
assumptions to be used by the firm, two companies in the same industry, with the same option plans and
number of options outstanding can come up with wildly different results.
Perhaps more important than what was disclosed is what was not disclosed. Thirtyone firms did
not disclose any cost, while others had incomplete disclosures. Those not disclosing any cost claim the cost
is immaterial and/or the pro forma income numbers are not materially different from those reported. The
next section shows the estimated cost for these firms is anything but immaterial.
Estimates of the True ESO Cost
Balsam (1994) suggest extending the method of accounting for stock appreciation rights (SARs) to
ESOs. While a precise implementation of that method requires knowledge of the grant and exercise dates,
as well as the vesting period and stock price at the end of each reporting period, the following estimation
was performed:18 19
Estimated Cost = (ESOt-1-ESOc)*(Pt � Pt-1) + max[ESOg*(Pt � Eg),0] � ESOe *(Pt � Eg) (1)
where:
ESOt-1=ESOs outstanding at the beginning of the calender year,
ESOg = ESOs granted during current year,
ESOe = ESOs exercised during current year,
ESOc = ESOs cancelled during current year.
12
Pt = share price at the end of the calendar year,
Pt-1 = share price at the beginning of the calendar year,
Eg = exercise price of shares granted during the current year.
Due to lack of detailed information, the estimation assumes immediate vesting, which then allows
for the mark-to-market treatment, and that the weighted average stock price when the ESOs are exercised is
equal to the weighted average stock price for the ESOs granted during the year. Table 2 contains these
estimates, which are much larger than the disclosures reported by the companies and summarized in table
1. For the 116 firms for which this estimate could be computed, panel A of table 2 shows that the cost,
were significantly greater than that disclosed by those same firms. For the 161 sample firms with available
data, the disclosed ESO cost ranged from a minimum of ($1,722,000) to a maximum of $142,000,000,
with a mean of $2,965,000 and a median of $417,000. As a percent of income available to common
shareholders the amounts range from a minimum (19.3) percent to a maximum of 312 percent, with of
mean of 12.6 percent and median of 3.4 percent. For the 161 firms, the ESO cost estimated by equation
(1) ranged from a minimum of ($56,107,000) to a maximum of $5,928,798,000, with a mean of
$63,525,000 and a median of $485,000. As a percent of income available to common shareholders, the
amounts range from a minimum (361) percent to a maximum of 1,200 percent, with a mean of 30.7 percent
and median of 7.1 percent. Both statistically (Wilcoxon p-value =0.0731) and economically, the amounts
disclosed are significantly less than the estimated cost. Focusing on the subsample of firms which reported
immaterial effects (see Panel B), the estimated costs (for 26 of those firms) range from a minimum of
($19,719,000) to a maximum of $655,624,000, with a mean of $42,467,000 and a median of $164,000.
As a percent of income available to common shareholders, the amounts range from a minimum of (45.5) to
a maximum of 126 percent, with a mean of 11.2 and median of 4.3 percent. While obviously the
percentages are affected by small denominators, i.e., close to zero income available to common
shareholders for some firms, the median dollar amounts and percentages appear to be economically
significant.
13
Echoing their position with respect to the exposure draft, companies might still take the position
that this is not an expense. They lobbied against the promulgation insisting that because the grant and
exercise of an ESO do not result in the expenditure of assets, ESOs do not meet the definition of an
expense. While it is true that the grant and exercise of an ESO does not require the expenditure of
corporate assets, many companies, while granting ESOs, also engage in costly stock repurchases (Jereski
1997, Lowenstein 1997), some as a matter of policy to avoid the dilution in EPS associated with ESOs
(DiStefano 1997, McGee and Ip 1997, Weisbenner 2000). Assuming fungibility of shares, the difference
between the price a company pays to reacquire its shares and the price it receives upon exercise of the ESO
can be thought of as a direct cost to the company, calculated as follows:
Estimated Cost = ESOe * (Pp - Ep) (2)
where:
ESOe = number of ESOs exercised during the year,
Pp = weighted average price per share paid for repurchases during the year,
Ep = weighted average exercise price for ESOs exercised during the year.
Only 58 of the 177 firms in the sample engaged in stock buybacks during 1996, and only 38 of those had
sufficient buybacks, i.e., in excess of ESOs exercised in 1996, to cover ESO exercises. Table 3 shows
both the estimated and disclosed cost for these subsamples. For the 58 firms, panel A of table 3 shows
that the cost, i.e., net cash outflows, were significantly greater than that disclosed by those same firms.20
For the 58 firms the disclosed cost ranged from a minimum of ($1,722,000) to a maximum of
$142,000,000, with a mean of $6,219,000 and a median of $502,000. As a percent of income available to
common shareholders the amounts range from a minimum (19) percent to a maximum of 84 percent, with
of mean of 5.5 percent and median of 2.1 percent. For the 58 firms the estimated cost ranged from a
minimum of $1,000 to a maximum of $845,000,000, with a mean of $31,203,000 and a median of
$823,000. As a percent of income available to common shareholders the amounts range from a minimum 0
percent to a maximum of 590 percent, with a mean of 17.9 percent and median of 4.6 percent. Both
statistically (Wilcoxon p-value=0.0016) and economically, the amounts disclosed are significantly less than
14
the estimated costs. 21
A Caveat
One reason the disclosed cost may be less than that estimated is that Statement No. 123 requires
that the cost be amortized over the vesting period of the ESOs, but instructs firms to ignore options granted
prior to 1995. Effectively the FASB is phasing in the disclosure requirements, and for firms with vesting
periods in excess of one year, the amount recognized in future years will be greater than that recognized
currently. The following numerical example will illustrate:
Assumptions:
� three year vesting period
� all ESOs granted mid-year
� 100,000 ESOs granted each year from 1993-1998
� each option has a fair value at the time of grant of $3
The expense disclosed each period would be calculated as follows:
1996 � 1/3 * (300,000) + 1/3 * (300,000) * ½ = 150,000
1997 � 1/3 * (300,000) + 1/3 * (300,000) + 1/3 * (300,000) * ½ = 250,000
1998 � 1/3 * (300,000) * ½ + 1/3 * (300,000) + 1/3 * (300,000) + 1/3 * (300,000) * ½ = 300,000
Using the simplified assumptions in the example, which assume no change in value of ESOs granted each
year, the cost disclosed would double from 1996 to 1998 when this company has fully phased in Statement
No. 123.
Valuation Effects (The results presented in tables 4-7) are not analyzed here but the findings are
summarized in both the introduction and summary and conclusions)
We first regress MVE of sample employer firms on the F/S bottom lines of BE and NI as modeled
in equation (3) below to determine the value relevance of reported numbers both before and after the
promulgation of SFAS No. 123 in 1995. Then we partition the bottom line numbers to include a net
15
income dummy (NIdummy) for negative earnings, and assets and liabilities components of book value as
the latter is directly effected by SARs. We use the NI dummy to control for the valuation effect of negative
earnings, i.e., the decline in value relevance of NI in financially distressed and loss firms, observed by prior
research (see, e.g., Hayn, 1995; Collins et al., 1997, 1999; Barth et al., 1998). The basic EBO model
specifications estimated for four years around the promulgation of SFAS No. 123, are the following:
MVEit = β°t + β1t BVEit + β2 t NIit +εit (3)
MVEit = β°t + β1t TAit + β2 t TLit + β3 t NIit + β4 t NIdummyit + εit (4)
where, i and t are the firm and year subscripts, respectively, and the variables, all defined previously, are
deflated by the number of common stock shares outstanding at each fiscal year end to control for size
differences.
We expect the coefficients of both NI and BVE to have significant coefficient estimates and the
significance of NI to decline after the disclosures stipulated by SFAS No. 123 since informative ESO
information disclosures that are expected to effect prices is not reflected in the reported NI. We further
expect a negative and significant coefficient for the NIdummy and BE to be more value relevant in such
loss firms. The disaggregated components of book value, TA and TL are expected to be significant and the
significance of TL to improve as the SAR related compensation expense and liability are recognized. The
results are reported in Table 7.
(Place Table 4 about here)
Next, we estimate the following model where NI is partitioned into NI before compensation
expense (NIBC) and estimated compensation cost (ECC) to compare the value-relevance of our several
estimates of compensation cost and to determine if the valuation model has a higher explanatory power
with the compensation cost included as an independent variable.
MVEit = β°t + β1t BVE it + β2 t NIBC it + β3 t ECCit + β4 t NIdummyit + εit (5)
where, ECC is different compensation cost estimates:
i) the compensation cost disclosed by the firm in its footnote related to its stock option footnotes,
calculated by taking the difference between the reported and proforma NI, one of the
disclosures mandated by SFAS No. 123.
ii) the compensation cost estimated in equation (1) in line with the mark-to-market accounting
16
used for SAR type stock options
iii) the compensation expense estimated in equation (2) based on the actual reacquisition cost of
stock to be issued to executives upon exercise of their options
iv) the estimated value of the stock options calculated by Compustat using the modified Black-
Scholes valuation model based on the firm-specific assumptions taken from the proxy
statements that results the same model to be used for all firms.
and all the other variables are as defined earlier.
In the results to be presented in panels A and B of Table 7, we expect all cost estimates to be
significant in varying degrees and the model to be better specified compared to model (3). Under the
caveat that the use of R2 in making inferences on incremental value-relevance has its limitations, the
difference between the R2s of regressions estimated in (4) and (5) can be attributed to the incremental
explanatory power of the estimated compensation cost.
Summary and Conclusion
This study examines firm implementation of SFAS No. 123: Accounting for Stock-Based
Compensation by examining the footnote disclosure in firm�s 10_K reports and showes : (1) firms are
electing the disclosure alternative, thereby continuing to avoid recognizing expense for most of their ESOs,
(2) the amounts disclosed as compensation cost are inadequate when compared to the estimates of the true
compensation cost, and (3) the amounts involved are material when compared with net income.
Summarizing the findings, all firms in the 1996 sample elected the disclosure alternative, although 31 of
those firms claimed immateriality and did not provide those disclosures. The amounts disclosed were
significantly less than that estimated using our alternative procedures of estimating the cost. We next use a longer time period, hence a larger (314 firm-years) sample to document the
financial profiles and ESO related variables of the sample. We also report the adequacy of ESO costs
disclosed in terms of reflecting the true cost to the company or the true value of the benefits derived from
the services of the employees vis a vis alternative ESO cost estimates. Specifically, we compare the fair
value cost computed by the firm, using any option pricing model they want, and disclosed in the footnotes
17
to financial statements under SFAS No. 123, i.e., the proforma adjustment to net income, with the
following alternative proxies: i)an estimate based on opportunity cost of granting the option, i.e., the cash
flow differential between the cash outlay for share repurchases which are then given employees upon
exercise of their options and the cash inflow from the exercise, ii) an option value estimated by using a
uniform Black-Scholes option pricing model and uniform assumptions for all firms , obtained from the
Compustat-ExecuComp database, iii) a mark-to-market cost estimate currently used for calculating
compensation expense for stock appreciation rights (SARs)22, suggested and shown to be equivalent to
stock based compensation in Balsam (1994), and iv) a cost estimate based on the tax benefit allowed the
firm by IRS upon exercise of the options.
Finally, a valuation model conditional on book values and earnings (Ohlson, 1995) is used to
evaluate the value-relevance of the reported bottom lines of ESO granting firms, the fair value cost
disclosure mandated by the SFAS No. 123, and our alternative ESO cost estimates. We assume that
market efficiently and rationally prices the firms with ESO plans and test whether the new disclosures and
other alternative cost estimates reflect the information in prices . Since the relevance of the cost or revenue
item in question and how reliably it is measured affect how well bottom lines of financial statements reflect
information about firm value, we expect a stronger relation between value of the firm and the most
informative ESO cost estimate. The findings indicate that (1) the amounts disclosed as compensation cost
are inadequate when compared to the estimates of the true compensation cost, (2) the ESO cost estimates
are value relevant., and (3) In general, ESO costs are not perceived as regular expenses of the company;
that is, the incentive effects of ESOs seem to dominate its costs to the company.
Overall, the study is designed to shed light on a timely and controversial financial reporting issue
from a valuation perspective. It will provide feedback to the Financial Accounting Standards Board for its
controversial rule on stock options and will provide insight to the International Accounting Standards
Board (IASB) in its current deliberations at the wake of setting the international accounting standard for
18
stock options. In issuing Statement No. 123, and urging recognition, the FASB argued that disclosure did
not take the place of recognition, that it was insufficient in itself. Given that all firms in our sample have
elected to disclose, the issue for the FASB to consider is whether Statement No. 123 has achieved its goal.
The valuation part of this study provides feedback to the FASB in terms of how well the bottom lines of
these firms reflect the fair value of the stock options with and without the recognition of a relevant ESO
cost. One obvious route the FASB will probably choose not to revisit is to try to mandate recognition.
Indeed we provide some support to the final non-recognition decision of the FASB since most of the ESO
cost estimates we use have positive valuation coefficients and hence are not assessed as regular expenses by
market participants. Alternatively, the FASB may want to investigate if disclosure can be improved or
simplified. One suggestion would be to present the pro forma numbers parenthetically on the face of the
income statement. While it may be politically too late for the FASB to reconsider the accounting for stock
options, this study will provide a timely insight for the IASB to consider in their current deliberations on
how to measure and disclose ESOs.
19
End Notes
1 .Executive stock options have lately become the largest component of executive compensation. While they represented only one-fifth of total CEO compensation back in 1984, they constituted one-third of the total package by 1990 and 1991 (Yermack, 1995) and reached 36% in most industries by 1996 (Murphy, 1998). 2 SARs are similar to options in terms of their payout to the executive. The only difference is that upon exercise, the executive receives the excess of the current stock price over the exercise price in cash so that the executive avoids the cash outlay necessary to exercise his options. 3 For some projects, the steering committee of the IASB publishes a neutral Issues Paper and invite comments to help the committee develop its tentative views. It is now welcoming comment letters on G4+1 Discussion Paper "Accounting for Share-based Payment (2000) which are published in their website. 4 Matsunaga (1995, note 6) finds only five % of his sample firms issued options with an exercise price below the fair market value at the grant date. Core and Guay (2000) report that that "compensation cost" variable is reported for only 25% of their sample firms and it is mostly reported by low-growth industries such as utilities. 5 See Beresford (1995). 1786 comment letters were received on the exposure draft (SFAS No. 123, paragraph 379). 6Amir and Ziv (1997) also state that disclosed information may be assessed as being less reliable.
7 Not all companies that have ESO plans actually grant options.
8 Firms with December 31, 1996 fiscal years were the first affected by the standard.
9 Later on, 21 year 1999 and year 2000 firms were added to the sample making the sample 117 firms (314 firm years). 10 Papers similar in spirit and methodology are the Amir(1996)that uses both book value and net income and Choi et al. (1997) that uses a "balance-sheet" model to determine whether unreconized post retirement benefits other than pensions are value-relevant. 11 Income could be higher under Statement No. 123 than under Opinion No. 25 and related pronouncements because Statement No. 123 results in a lower charge for variable stock option plans. See Kieso and Weygandt (1996) for further explanation.
12 They still must recognize expense for fixed ESOs granted at below the market price on the grant date, and as alluded to in note 8, variable plans.
13 When firms reporting that the effect is immaterial are included in the analysis, a zero is imputed for their disclosed cost.
14 Focusing on the 146 firms reporting pro forma effects the mean is $3,431,252 and the median $624,823.
15 Focusing on the 146 firms reporting pro forma effects the mean is 14.46 percent and the median 5.17 percent.
16 In many cases a range rather than an actual value is disclosed. In those cases the midpoint of the range is used.
17 The value of ESOs depends on firm specific variables and the expected life of the option, expected volatility and
20
expected dividends differ across firms. While the risk-free rate of interest does not differ across companies, according to Statement No. 123, it should be the risk-free rate for a treasury bond with a maturity equal to the expected life of the option, which does vary across firms. 18 . Note that the expense estimated by equation (1) will be overstated to the extent that the options cancelled were in the money at the beginning of the year. This occurs because a liability would have been set up (under the SAR approach) at the end of the previous year and would be reversed, that is taken into income, in the year of cancellation. Unfortunately without detailed data on exercise prices there is no way of knowing whether the options were in the money at the beginning of the year. Rather the adjustment performed, by subtracting the cancelled options from those outstanding at the beginning of the year, ensures that no additional expense is recognized for those options.
19. If the market price at the end of the year is less than that at the beginning of the year this formula may understate the expense for the following reason. Under FASB Interpretation No. 28, if the price drops during the year the company is allowed to reduce its compensation expense to recognize the decrease in its liability, with the reduction limited to the liability. Unfortunately there is no way of knowing what the liability would be if the SAR approach were used, and thus the estimation assumes the liability is sufficient to allow recognition of the effect of the drop in stock price. If the liability were less than that amount, then the first component of equation (1) is understated and hence, so is the expense.
20. The results for the 38 firm subsample were comparable (see panel B of table 3).
21 The results are qualitatively the same for firms reporting immaterial effects but are not reported in the table due to small sample size (N=9).
21
References Aboody, D., 1996. Market valuation of Employee stock options. Journal od Accounting and Economics, 22, 357-391. Amir, E., and A. Ziv. 1997. Recognition, disclosure or delay: Timing the adoption of SFAS No. 106. Journal of Accounting Research 35 (Spring): 61-81. Barth, M. E., W. H. Beaver, and W. R. Landsman. 1998. Relative valuation roles of equity book value and net income as a function of financial health. Journal of Accounting & Economics 25: 1-34. Barth, Mary E. 2000. Valuation-based accounting research: implications for financial reporting and opportunities for future research. Accounting and Finance 40, 7-31. Balsam, Steven. 1994. Extending the Method of Accounting for Stock Appreciation Rights to Employee Stock Options, Accounting Horizons, (December): 52-60. Beresford, Dennis R. 1995. How should the FASB be judged? Accounting Horizons 9 (June): 56-61. Bernard, V., and K. Schipper. 1994. Recognition and disclosure in financial reporting. Working paper, University of Michigan, Ann Harbor, MI and University of Chicago, Chicago, IL. Collins, D. W., E. L. Maydew, and I. S. Weiss. 1997. Changes in the value-relevance of earnings and book values over the past forty years. Journal of Accounting & Economics 24: 39-67. ., M. Pincus, and H. Xie. 1999. Equity valuation and negative earnings: The role of book value of equity. The Accounting Review 74 (January): 29-61. Core J. and W. Guay. 2000. Stock options plans for non-executive employees. Working Paper, the Wharton School. DiStefano, Joseph N. 1997. Scores of managers hit market jackpot, The Philadelphia Inquirer, June 29, 1997, pp. D1 and D14. Financial Accounting Standards Board. 1993. Proposed Statement of Financial Accounting Standards: Accounting for Stock-based Compensation. Norwalk, Conn: FASB. Financial Accounting Standards Board. 1995. Statement of Financial Accounting Standards: Accounting for Stock-based Compensation. Norwalk, Conn: FASB. Guay, Wayne R.. 1999. The sensitivity of CEO wealth to equity risk: an analysis of the magnitude and determinants. Journal of Financial Economics 53, 43-71. Haugen, Robert A> and Lemma W. Senbet. 1981. Resolving the agency problems of external capital through
22
options. Journal of Finance 36, 629-647. Hayn, C. 1995. The information content of losses. Journal of Financial Economics 20: 125-153. Imhoff, E.A. 1993. The effects of recognition versus disclosure on shareholder risk and executive compensation. Journal of Accounting, Auditing and Finance 8 (Fall): 335-368. . 1995. Is footnote disclosure an adequate alternative to financial statement recognition? The Journal of Financial Statement Analysis 1 (Fall): 70-81. .Jereski, Laura. 1997. Share the Wealth: As Options Proliferate, Investors Question Effect on Bottom Line, The Wall Street Journal, January 14, 1997, pp. A1 and A10. Johnson, L. T. 1992. Research on disclosure. Accounting Horizons 6 (March): 101-103. Kieso, Donald E. and Jerry J. Weygandt. 1996. Update Supplement-1996 to accompany and be integrated with Eight Edition Intermediate Accounting, John Wiley & Sons, Inc. Lees, L. and D. Scott. 1998. The value-relevance of stock-based employee compensation disclosures. Working Paper, Texas A&M University and Washington State University. Lowenstein, Roger. 1997. Intrinsic Value: Coming Clean on Company Stock Options, The Wall Street Journal, June 26, 1997, p. C1. Matsunaga, Steven R. 1995. The Effects of Financial Reporting Costs on the Use of Employee Stock Options, The Accounting Review, vol. 70, 1-26. McGee, Suzanne and Ip, Greg. 1997. Stock Buybacks Aren't Always Good Sign for Investors, The Wall Street Journal, July 7, 1997, pp. C1 and C2. Murphy, Kevin J. 1998. Executive Compensation, Working Paper, University of Southern California. Ohlson, J. A. 1991. The theory of value and earnings, and an introduction to the Ball-Brown analysis. Contemporary Accounting Research (Fall): 1-19. ., and S. H. Penman. 1992. Diaggregated accounting data as explanatory variables for returns. Journal of Accounting, Auditing & Finance (Fall): 553-573. . 1995. Earnings, book values and dividends in security valuation. Contemporary Accounting Research 11, 661-687. Rubinstein, Mark. 1995. On the Accounting Valuation of Employee Stock Options. Journal of Derivatives Fall, Schipper, K. 1994. Academic accounting research and the standard setting process. Accounting Horizons (December): 61-73.
23
Smith, C. and R. Watts.1992. The investment opportunity set and corporate financing, dividends, and Compensation policies. Journal of Financial Economics 32, 263-292. Weisbenner, J. Scott. 2000. Corporate share repurchases in the 1990s: What role do stock options play. FEDS Working Paper No. 2000-29, Board of Governers of the Federal Reserve System and MIT. Yermack, David. 1995. Do corporations award CEO stock options effectively?, Journal of Financial Economics 39, 237-269.
24
Table 1 Descriptive statistics- Company Disclosures in 1996 (dollar and share amounts in thousands) ______________________________________________________________________________________ OBS MEAN MIN MED MAX ST.DV Proforma Adj. 177 2830 -1722 394 142000 13817 DproformaAdj 177 0.119 -0.19 0.034 3.122 0.319 Rf 143 6.188 4.500 6.250 8.500 0.463 ELife 143 5.856 1.000 5.000 10.00 2.245 EVol 142 53.34 12.90 45.00 235.0 31.84 EDiv 142 0.913 0.000 0.000 12.00 1.824 Ng 175 845 0 106 815 12 Ng /CSsh 175 0.032 0.000 0.007 0.039 0.050 _________________________________________________________________________________________ Proforma Adj. = Disclosed cost of ESO grants, or difference between reported and pro forma net income. When firm reports cost is immaterial, it is coded as zero here. Dproforma Adj.= Expense deflated by absolute value of reported net income Rf = Risk free interest rate used by the firm in valuing ESOs. ELife =Expected life of ESO used by firm in valuing ESOs. EVol =Expected volatility of returns used by firm in valuing ESOs. EDiv =Expected dividend yield used by firm in valuing ESOs. Ng =Number of ESOs granted during 1996. Ng /CSsh = Ng deflated by common shares outstanding at end of year.
25
Table 2 Descriptive statistics-Estimates calculated using SAR approach in 1996 (dollar and share amounts in thousands) _____________________________________________________________________________________ Panel A: for the whole sample OBS MEAN MIN MED MAX ST.DV Proforma Adj. 161 2965 -1722 417 142000 14455 DProforma Adj. 161 0.126 0.010 0.097 3.122 0.333 SARExp 161 63525 -56107 485 5928798 8493166 DSARExp 161 0.307 -3.606 0.071 11.999 1.505 ____________________________________________________________________________________ Panel B: for subsample of firms reporting zero or immaterial effects OBS MEAN MIN MED MAX ST.DV Proforma Adj 26 0 0 0 0 0 DProforma Adj 26 0.000 0.000 0.000 0.000 0.000 SARExp 26 42467 -19719 164 655624 138154 DSARExp 26 0.112 -0.455 0.043 1.260 0.368 ____________________________________________________________________________________ Proforma Adj = Disclosed cost of ESO grants, or difference between reported and pro forma net income. When firm reports that the cost is immaterial, it is coded as zero in the table. DProforma Adj =Expense deflated by absolute value of reported net income SARExp = Alternative expense calculated using equation (1) DSARExp = Expense2 deflated by absolute value of reported net income
26
Table 3 Descriptive statistics-subsample of firms with share repurchases in 1996 (dollar and share amounts in thousands) _________________________________________________________________________________________ Panel A: Full sample OBS MEAN MIN MED MAX ST.DV Proforma Adj 58 6219 -1722 502 142000 23690 DProforma Adj 58 0.055 -0.193 0.021 0.837 0.133 TSExp 58 31203 1 823 845000 118871 DTSExp 58 0.179 0.000 0.046 5.896 0.773 Ne 58 1024 0.1 107 17000 2832 Proceeds/sh 58 18.974 0.072 11.216 175.127 27.438 Nr 58 2626 10 268 49641 7274 Cost/sh 58 41.055 0.553 19.959 474.724 76.558 ___________________________________________________________________________________ Panel B: excluding firms where repurchases are less than ESO exercises Proforma Adj 39 8703 0 488 142000 28645 DProformaAdj 39 0.047 0.000 0.020 0.502 0.089 TSExp 39 41172 1 626 845000 143456 D SExp 39 0.057 0.000 0.032 0.313 0.067 NExer 39 1216 0 98 17000 3273 Procps 39 17.402 0.289 11.120 97.591 20.290 NRepur 39 3731 11 521 49641 8659 Costps 39 36.976 0.553 20.398 352.252 59.141 __________________________________________________________________________________ Proforma Adj =disclosed cost of ESO grants, or difference between reported and pro forma net income. When firm reports cost is immaterial, it is coded as zero here. DProforma Adj =Expense deflated by absolute value of reported net income TSExp =alternative expense calculated by taking the per share difference between the price paid on share repurchases and the price received per share on ESO exercises (including tax benefit) and multiplying by the number of ESO exercised during 1996. DTSExp =Expense2 deflated by absolute value of reported net income Ne =number of ESOs exercised during 1996 Proceeds/sh =per share proceeds (including tax benefit) on ESO exercises. Nr =number of shares repurchased during 1996. Cost/sh =per share cost of share repurchases.
27
TABLE 4
Financial Profiles of the Sample of ESO Firms (1996-2000)
(in millions, standard deviations in parenthesis)
1996 N 1997 N 1998 N 1999-2000 N 1996-2000 N
NI 418.13 (919.05) 95 449.23
(1135.36) 93 510.22 (1169.71) 87 1720.10
(2237.94) 26 418.24 301
TA 8445.13 (20605.96) 95 9558.62
(23406.70) 93 11412.50 (27411.19) 87 17869.38
(15688.58) 26 8917.36 301
TL 6379.15 (17974.61) 95 7163.81
(20391.63) 93 8661.88 (23961.06) 87 8052.81
(7142.63) 26 6730.36 301
BVE 2049.40 (3651.39) 95 2365.88
(4231.56) 93 2736.27 (4816.81) 87 9769.28
(10895.90) 26 2168.69 301
MVE 9061.04 (21198.73) 95 11495.93
(27349.43) 92 15932.74 (37669.13) 86 81454.65
(124315.49) 26 10998.79 299
TL/BVE 2.25 (4.88) 95 2.02
(4.86) 93 1.66 (5.40) 87 1.22
(1.27) 26 1.81 301
TL/MVE 1.11 (3.43) 95 1.11
(2.60) 92 1.16 (2.65) 86 0.36
(0.60) 26 1.03 299
SG&A 957.20 (1716.47) 59 1053.00
(1843.87) 65 1211.04 (2021.30) 60 3758.60
(3317.77) 21 963.81 205
SG&A/NI 0.98 (15.66) 73 18.17
(118.44) 70 2.47 (19.34) 64 2.60
(3.33) 25 6.47 232
NI/TA -0.005 (0.19) 95 -0.10
(0.44) 93 -0.06 (0.39) 87 0.11
(0.06) 26 -0.05 301
NI/BVE -0.07 (0.92) 95 -0.02
(1.16) 93 0.26 (1.36) 87 0.22
(0.17) 26 0.05 301
BVE/MVE
TABLE 5
Averages (std. dev.) for Stock Option Related Variables (in millions)
1996 - 1998 1996 1997 1998 Average N
T/S purchased ($) 310.44 (644.97)
730.72 (3215.36)
686.42 (2713.39)
582.321 (2469.172)
178
Proceeds from exercise of options ($)
48.53 (114.29)
56.66 (118.69)
75.74 (138.55)
59.858 (123.741)
197
# of T/S purchased 9.36 (21.35)
31.40 (145.05)
29.45 (142.48)
23.537 (118.299)
133
# of options outstanding 17.03 (40.20)
19.60 (44.10)
21.04 (45.57)
19.170 (43.146)
268
# of options granted 4.43 (7.46)
4.81 (8.63)
6.06 (8.37)
5.066 (8.148)
261
# of options exercised 2.84 (6.18)
3.43 (7.33)
3.93 (9.19)
3.380 (7.599)
241
29
TABLE 6
Averages (std. dev.) of estimated ESO Costs (in millions of $)
1996 1997 1998 1999-2000 1996-2000
Proforma Adj. To NI
11.80
(15.95)
19.06
(29.53)
27.75
(45.38)
1459.99
(2021.49)
145.34
(715.87)
% of SG&A 0.08
(0.11)
0.07
(0.09)
0.07
(0.07)
0.93
(1.51)
0.15
(0.52)
% of NI 0.20
(0.34)
0.34
(1.23)
0.35
(1.04)
0.80
(0.21)
0.34
(0.92)
BLK_VALU 46.13
(65.46)
73.00
(154.42)
807.49
(5753.58)
966.06
(1686.90)
364.85
(3128.01)
% of SG&A 0.15
(0.18)
0.16
(0.26)
0.38
(1.63)
0.51
(0.89)
0.25
(0.91)
% of NI 0.48
(1.05)
0.97
(4.13)
2.11
(7.60)
0.84
(0.95)
1.09
(4.69)
Tax Benefit 18.64
(35.35)
25.44
(59.68)
36.28
(81.08)
407.69
(1100.20)
101.39
(493.26)
% of SG&A 0.05
(0.08)
0.04
(0.07)
0.03
(0.04)
0.24
(0.46)
0.07
(0.21)
% of NI 0.14
(0.37)
0.29
(1.10)
0.18
(0.42)
0.18
(0.16)
0.21
(0.66)
Tax B. (1 � t) / t 39.76
(72.33)
51.98
(124.68)
73.48
(165.57)
825.08
(2104.50)
202.12
(965.21)
% of SG&A 0.10
(0.14)
0.08
(0.11)
0.06
(0.07)
0.33
(0.53)
0.12
(0.26)
% of NI 0.25
(0.50)
0.30
(0.34)
0.17
(0.18)
0.35
(0.34)
0.27
(0.37)
30
TABLE 6 (continued)
Averages (std. dev.) of estimated ESO Costs (in millions of $)
1996 1997 1998 1999-2000 1996-2000
Repurchase Cost 100.08
(176.03)
168.02
(368.41)
145.09
(438.88)
137.98
(351.39)
% of SG&A 0.09
(0.14)
0.08
(0.08)
0.07
(0.10)
0.08
(0.11)
% of NI 0.35
(0.98)
0.53
(1.99)
0.18
(0.22)
0.34
(1.23)
SAR Accounting 153.08
(678.74)
177.92
(507.24)
259.26
(968.32)
188.22
(720.57)
% of SG&A 0.21
(0.39)
0.12
(0.18)
0.17
(0.43)
0.15
(0.32)
% of NI 0.36
(0.59)
0.37
(0.70)
0.34
(0.97)
0.36
(0.75)
(Pt � Pe) x Ne 589.91
(4449.63)
-27.04
(2115.70)
270.26
(1898.82)
273.37
(3036.67)
% of SG&A 1.65
(2.82)
6.45
(46.16)
0.87
(2.40)
0.74
(1.57)
% of NI 3.88
(10.05)
5.67
(30.60)
1.94
(3.61)
2.45
(7.69)
31
TABLE 7
Regressions of Price on reported Net Income, Book Value of Equity and alternative estimates of ESO Cost: 1996-2000
Full Model: Pi t = β
! + β1 NI i t + β2 BVi t + β3 NIdum i t + β4 ESOCi t + εi t
Panel A:
1 Disclosed ESOC estimates are: PNI adj = proforma adjustment (fair value of options estimated by the firm for the stock options granted). BLK_VAL = Compustat estimated Black_Scholes Value extrapolated to all the employees of the firm. TB = Tax benefit on exercise date. TB(t-1)/t = Estimated after-tax cost due to the difference between exercise price and market price on exercise date.
Disclosed ESO Cost Estimates (ESOC) 1
β!
NI BV NI dum PNI adj
BLK_VAL
TB TB(t-1)/t Adj. R2
Model 1: (N = 299)
Coefficient 25.14 4.53 0.64 0.43
(p-value) 0.00 0.00 0.00
Model 2: (N = 299)
Coefficient 29.07 3.29 0.68 -10.98 0.45
(p-value) 0.00 0.00 0.00 0.00
Model 3: (N = 299) Coefficient 29.13 3.40 0.70 -10.43 -1.08 0.43
(p-value) 0.00 0.00 0.00 0.00 0.51
Model 4: (N = 217) Coefficient 31.09 5.52 0.38 -7.24 0.08 0.48
(p-value) 0.00 0.00 0.01 0.09 0.56
Model 5: (N = 136) Coefficient 20.95 7.55 -0.15 6.61 53.44 0.42
(p-value) 0.00 0.00 0.61 0.27 0.00
Model 6: (N = 131) Coefficient 22.65 8.19 -0.32 6.58 22.19 0.39
(p-value) 0.00 0.00 0.27 0.32 0.00007
32
Panel B:
1 Alternative ESOC estimates are: T/S Cost = (Pr - Pe)Nr + (Pi - Pe)(Ne - Nr) if Nr<Ne = (Pr - Pe )Ne if Nr>Ne. SAR Accounting = (N t-1 - Nc)( Pt - Pt-1)+(Ng - Ne)( Pt - Pe ). (Pt � Pe)Ne = exercise day accounting (assumes all shares corresponding to options can be sold at year-end prices.
Alternative ESOC Estimates 1
β!
NI BV NI dum T/S cost
SAR accounting
(Pt � Pe) x Ne
Adj. R2
Model 7: (N = 112)
Coefficient 20.89 2.52 1.06 -4.70 22.90 0.47
(p-value) 0.00 0.02 0.00 0.49 0.00
Model 8: (N = 264)
Coefficient 26.69 2.48 0.69 -11.04 1.50 0.56
(p-value) 0.00 0.00 0.00 0.00 0.00
Model 9: (N = 249) Coefficient 24.45 2.06 0.75 -10.43 -8.85 8.95 0.61
(p-value) 0.00 0.00 0.00 0.005 0.51 0.00
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1 .Executive stock options have lately become the largest component of executive compensation. While they represented only one-fifth of total CEO compensation back in 1984, they constituted one-third of the total package by 1990 and 1991 (Yermack, 1995) and reached 36% in most industries by 1996 (Murphy, 1998). 2 SARs are similar to options in terms of their payout to the executive. The only difference is that upon exercise, the executive receives the excess of the current stock price over the exercise price in cash so that the executive avoids the cash outlay necessary to exercise his options. 3 For some projects, the steering committee of the IASB publishes a neutral Issues Paper and invite comments to help the committee develop its tentative views. It is now welcoming comment letters on G4+1 Discussion Paper "Accounting for Share-based Payment (2000) which are published in their website. 4 Matsunaga (1995, note 6) finds only five % of his sample firms issued options with an exercise price below the fair market value at the grant date. Core and Guay (2000) report that that "compensation cost" variable is reported for only 25% of their sample firms and it is mostly reported by low-growth industries such as utilities. 5 See Beresford (1995). 1786 comment letters were received on the exposure draft (SFAS No. 123, paragraph 379). 6Amir and Ziv (1997) also state that disclosed information may be assessed as being less reliable.
7 Not all companies that have ESO plans actually grant options.
8 Firms with December 31, 1996 fiscal years were the first affected by the standard.
9 Later on, 21 year 1999 and year 2000 firms were added to the sample making the sample 117 firms (314 firm years). 10 Papers similar in spirit and methodology are the Amir(1996)that uses both book value and net income and Choi et al. (1997) that uses a "balance-sheet" model to determine whether unreconized post retirement benefits other than pensions are value-relevant. 11 Income could be higher under Statement No. 123 than under Opinion No. 25 and related pronouncements because Statement No. 123 results in a lower charge for variable stock option plans. See Kieso and Weygandt (1996) for further explanation.
12They still must recognize expense for fixed ESOs granted at below the market price on the grant date, and as alluded to in note 8, variable plans.
13.When firms reporting that the effect is immaterial are included in the analysis, a zero is imputed for their disclosed cost.
14 Focusing on the 146 firms reporting pro forma effects the mean is $3,431,252 and the median $624,823.
15 Focusing on the 146 firms reporting pro forma effects the mean is 14.46 percent and the median 5.17 percent.
16 In many cases a range rather than an actual value is disclosed. In those cases the midpoint of the range is used.
17 The value of ESOs depends on firm specific variables and the expected life of the option, expected volatility and expected dividends differ across firms. While the risk-free rate of interest does not differ across companies, according to Statement No. 123, it should be the risk-free rate for a treasury bond with a maturity equal to the expected life of the option, which does vary across firms. 18. Note that the expense estimated by equation (1) will be overstated to the extent that the options cancelled were in the
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money at the beginning of the year. This occurs because a liability would have been set up (under the SAR approach) at the end of the previous year and would be reversed, that is taken into income, in the year of cancellation. Unfortunately without detailed data on exercise prices there is no way of knowing whether the options were in the money at the beginning of the year. Rather the adjustment performed, by subtracting the cancelled options from those outstanding at the beginning of the year, ensures that no additional expense is recognized for those options.
19. If the market price at the end of the year is less than that at the beginning of the year this formula may understate the expense for the following reason. Under FASB Interpretation No. 28, if the price drops during the year the company is allowed to reduce its compensation expense to recognize the decrease in its liability, with the reduction limited to the liability. Unfortunately there is no way of knowing what the liability would be if the SAR approach were used, and thus the estimation assumes the liability is sufficient to allow recognition of the effect of the drop in stock price. If the liability were less than that amount, then the first component of equation (1) is understated and hence, so is the expense.
20. The results for the 38 firm subsample were comparable (see panel B of table 3).
21 The results are qualitatively the same for firms reporting immaterial effects but are not reported in the table due to small sample size (N=9).
