The Value Relevance of Alternative Methods of Accounting for Employee Stock Options

52 Pages Posted: 1 Aug 2004

See all articles by Wayne R. Landsman

Wayne R. Landsman

University of North Carolina Kenan-Flagler Business School

Ken V. Peasnell

Lancaster University - Department of Accounting and Finance

Peter F. Pope

Bocconi University; London School of Economics and Political Science

Shu Yeh

National Taiwan University - Department of Accounting

Date Written: July 29, 2004

Abstract

We use the residual income valuation framework to compare the equity valuation implications of four approaches to employee stock options (ESOs) accounting proposed by regulators: APB 25 "recognize nothing", SFAS 123 preferred "recognize ESO expense", FASB Exposure Draft "recognize and expense ESO asset" and "recognize ESO asset and ESO liability". Our theoretical analysis shows that only a version that involves grant date recognition of an asset and a liability, and subsequent marking-to-market of the liability, results in accounting numbers that accurately reflect the dilution effects of ESOs on current shareholder value. The other accounting methods lead to overstatement of current equity value. Out-of-sample and in-sample empirical tests are used to assess value relevance of the four accounting methods. The out-of-sample tests compare contemporaneous equity market value predictions based on each of the four methods. The in-sample tests compare the model explanatory power from estimating equations relating to each of the four accounting methods. The out-of-sample tests indicate the method with grant date asset and liability recognition has the lowest prediction errors, followed by the Exposure Draft method, the SFAS 123 method, and the APB 25 method. Findings from the in-sample tests are largely consistent with our theoretical expectations and provide support for the grant date recognition of an ESO asset and liability.

Keywords: Employee stock options, value relevance

JEL Classification: G12, G13, M41, M44

Suggested Citation

Landsman, Wayne R. and Peasnell, Kenneth V. and Pope, Peter F. and Yeh, Shu, The Value Relevance of Alternative Methods of Accounting for Employee Stock Options (July 29, 2004). Available at SSRN: https://ssrn.com/abstract=570762 or http://dx.doi.org/10.2139/ssrn.570762

Wayne R. Landsman (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

McColl Building
Chapel Hill, NC 27599-3490
United States
919-962-3221 (Phone)
919-962-4727 (Fax)

Kenneth V. Peasnell

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
+44 1524 593631 (Phone)
+44 1524 847321 (Fax)

Peter F. Pope

Bocconi University ( email )

Dept of Accounting
Milan, 20136
Italy

London School of Economics and Political Science ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Shu Yeh

National Taiwan University - Department of Accounting ( email )

50 Lane 144, Section 4
Taipei 32026
Taiwan

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