The Economic Consequences of Recognition Versus Disclosure: Evidence from Employee Stock Options

Abstract

I examine how recognition versus disclosure of the fair value of stock compensation affects the compensation decision (the amount and structure of options awarded). The median firm in my sample disclosed fair value option costs equal to about 7% of profits in 1996 and 11% of profits in 2004. When fair value option costs are recognized, I find an average (median) reduction in option grants equal to 9% (0.4%) of absolute net income. The evidence indicates that firms substituted options with restricted stock during fair value recognition; however, I find no evidence of changes in option grants during the fair value disclosure pronouncement. These results suggest that managers and governing boards treat recognition differently from disclosure, such that the inclusion of fair values in summary total figures leads to systematic changes in the structure of contracts, while changes in the valuation method do not lead to such changes.

Keywords: recognition versus disclosure, economic consequences, employee stock options, FAS 123-R

JEL Classification: J33, M41, M44, M45