On the Accounting Valuation of Employee Stock Options

Abstract

In its exposure draft, "Accounting for Stock-based Compensation," FASB proposes that either the Black-Scholes or binomial option pricing model be used to expense employee stock options, and that the value of these options be measured on their grant date with typically modest ex post adjustment. This brings the accounting profession face to face with the Scylla of imposing too narrow a set of rules, which will force many firms to considerably misstate the value of their stock options, and the Charybdis of granting considerable latitude, which will increase non-comparability across financial statements of otherwise similar firms. This, of course, is a common trade-off afflicting many rules for external financial accounting.To examine the inherent dangers in navigating between these perils, this article develops a binomial valuation model that simultaneously takes into consideration the most significant differences between standard call options and employee stock options: longer maturity, delayed vesting, forfeiture, non-transferability, dilution, and taxes. The model uses sixteen input variables, many of them difficult to estimate. A firm seeking to overvalue its options could actually report values almost double those reported by an otherwise similar firm seeking to undervalue its options. As an alternative, FASB could consider exercise date accounting, under which an expense equal to the exercise value of the option is recognized at the time of exercise. This would achieve the long-sought external accounting goal of realizing stock options as compensation, while at the same time minimizing the potential for the revised accounting rules to motivate gaming behavior or non- comparable statements.

JEL Classification: G30