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Which approach to accounting for employee stock options best reflects market pricing?

Author

Listed:
  • Wayne R. Landsman

    (University of North Carolina at Chapel Hill)

  • Ken V. Peasnell

    (Lancaster University)

  • Peter F. Pope

    (Lancaster University)

  • Shu Yeh

    (National Taiwan University)

Abstract

We use a residual income valuation framework to compare equity valuation implications of four approaches to employee stock options (ESOs) accounting: APB 25 “recognize nothing”, SFAS 123 (revised) “recognize ESO expense”, FASB Exposure Draft “recognize and expense ESO asset” and “recognize ESO asset and liability”. Theoretical analysis shows only grant date recognition of an asset and liability, and subsequent marking-to-market of the liability, results in accounting numbers that capture the dilution effects of ESOs on current shareholder value. Out-of-sample equity market value prediction tests and in-sample comparisons of model explanatory power also support the “recognize ESO asset and liability” method.

Suggested Citation

  • Wayne R. Landsman & Ken V. Peasnell & Peter F. Pope & Shu Yeh, 2006. "Which approach to accounting for employee stock options best reflects market pricing?," Review of Accounting Studies, Springer, vol. 11(2), pages 203-245, September.
    • Handle: RePEc:spr:reaccs:v:11:y:2006:i:2:d:10.1007_s11142-006-9008-x
    DOI: 10.1007/s11142-006-9008-x
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    References listed on IDEAS

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    1. Mary E. Barth & William H. Beaver & John R. M. Hand & Wayne R. Landsman, 1999. "Accruals, Cash Flows, and Equity Values," Review of Accounting Studies, Springer, vol. 4(3), pages 205-229, December.
    2. Feng Li & M. H. Franco Wong, 2005. "Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant‐Pricing Model," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 43(1), pages 97-131, March.
    3. James A. Ohlson, 1999. "On Transitory Earnings," Review of Accounting Studies, Springer, vol. 4(3), pages 145-162, December.
    4. John R. M. Hand & Wayne R. Landsman, 2005. "The Pricing of Dividends in Equity Valuation," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 32(3-4), pages 435-469.
    5. Dechow, Patricia M. & Hutton, Amy P. & Sloan, Richard G., 1999. "An empirical assessment of the residual income valuation model1," Journal of Accounting and Economics, Elsevier, vol. 26(1-3), pages 1-34, January.
    6. Aboody, David, 1996. "Market valuation of employee stock options," Journal of Accounting and Economics, Elsevier, vol. 22(1-3), pages 357-391, October.
    7. James A. Ohlson & Beate E. Juettner-Nauroth, 2005. "Expected EPS and EPS Growth as Determinantsof Value," Review of Accounting Studies, Springer, vol. 10(2), pages 349-365, September.
    8. Vuong, Quang H, 1989. "Likelihood Ratio Tests for Model Selection and Non-nested Hypotheses," Econometrica, Econometric Society, vol. 57(2), pages 307-333, March.
    9. Kothari, S. P. & Zimmerman, Jerold L., 1995. "Price and return models," Journal of Accounting and Economics, Elsevier, vol. 20(2), pages 155-192, September.
    10. Hanlon, Michelle & Rajgopal, Shivaram & Shevlin, Terry, 2003. "Are executive stock options associated with future earnings?," Journal of Accounting and Economics, Elsevier, vol. 36(1-3), pages 3-43, December.
    11. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    12. John R. M. Hand & Wayne R. Landsman, 2005. "The Pricing of Dividends in Equity Valuation," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 32(3‐4), pages 435-469, April.
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    Cited by:

    1. Ken Peasnell, 2013. "Discussion of “Financial reporting for employee stock options: liabilities or equity”," Review of Accounting Studies, Springer, vol. 18(3), pages 683-691, September.
    2. Mary E. Barth & Leslie D. Hodder & Stephen R. Stubben, 2013. "Financial reporting for employee stock options: liabilities or equity?," Review of Accounting Studies, Springer, vol. 18(3), pages 642-682, September.

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    Keywords

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    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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