VALUATION OF EMPLOYEE RELOAD OPTIONS USING UTILITY MAXIMIZATION APPROACH

The reload provision in an employee stock option is an option enhancement that allows the employee to pay the strike upon exercising the stock option using his owned stocks and to receive new "reload" stock options. The usual Black–Scholes risk neutral valuation approach may not be appropriate to be adopted as the pricing vehicle for employee stock options, due to the non-transferability of the ownership of the options and the restriction on short selling of the firm's stocks as hedging strategy. In this paper, we present a general utility maximization framework to price non-tradeable employee stock options with reload provision. The risk aversion of the employee enters into the pricing model through the choice of the utility function. We examine how the value of the reload option to the employee is affected by the number of reloads outstanding, the risk aversion level and personal wealth. In particular, we explore how the reload provision may lower the difference between the cost of granting the option and the private option value and improve the compensation incentive of the option award.

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The Economic Dilution of Employee Stock Options: Diluted EPS for Valuation and Financial Reporting

The Accounting Review ◽

10.2308/accr.2002.77.3.627 ◽

2002 ◽

Vol 77 (3) ◽

pp. 627-652 ◽

Cited By ~ 61

Author(s):

John E. Core ◽

Wayne R. Guay ◽

S. P. Kothari

Keyword(s):

Financial Reporting ◽

Stock Price ◽

Stock Options ◽

Empirical Support ◽

Stock Option ◽

Employee Stock Options ◽

Economic Implications ◽

Employee Stock Option ◽

The Difference ◽

Biased Estimates

In this paper, we derive a measure of diluted EPS that incorporates the economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the options' dilutive effect, and thus overstates reported EPS. Using firm-wide data on 731 employee stock option plans, our proposed measure suggests that economic dilution from options is, on average, 100 percent greater than dilution in reported diluted EPS using the FASB treasury-stock method. We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per-share earnings as an input (e.g., Ohlson 1995) yield upwardly biased estimates of the market value of common stock. We predict that when the difference between our measure of economic dilution from options and the FASB treasury-stock method dilution from options is greater, the observed return-earnings and price-earnings coefficients will be smaller, and we provide some (albeit weak) empirical support for this prediction.

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SFAS No. 123 Disclosures and Discounted Cash Flow Valuation

Accounting Horizons ◽

10.2308/acch.2000.14.2.169 ◽

2000 ◽

Vol 14 (2) ◽

pp. 169-189 ◽

Cited By ~ 12

Author(s):

Leonard C. Soffer

Keyword(s):

Cash Flow ◽

Stock Options ◽

Stock Option ◽

Financial Statement ◽

Employee Stock Options ◽

Financial Statement Analysis ◽

Discounted Cash Flow ◽

Employee Stock Option ◽

Valuation Technique ◽

Discounted Cash Flow Valuation

One of the cornerstones of financial statement analysis is the discounted cash flow valuation. Despite the broad use of this valuation technique, and the economic importance of employee stock options to firm values, there is little guidance on how employee stock options should be incorporated in a valuation. This paper provides a comprehensive approach to doing so, including consideration of the income tax implications of option exercises, the simultaneity of equity and option valuation, and the use of the disclosures that were mandated recently by Statement of Financial Accounting Standards No. 123. The paper provides a comprehensive example using Microsoft's fiscal 1997 financial statements and employee stock option disclosure. This paper should be of interest to academics and practitioners involved in corporate valuation and financial statement analysis.

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Modifying the Black-Scholes-Merton model to calculate the cost of employee stock options

Managerial Finance ◽

10.1108/mf-12-2012-0257 ◽

2014 ◽

Vol 40 (1) ◽

pp. 2-32 ◽

Cited By ~ 2

Author(s):

John D. Finnerty

Keyword(s):

Utility Maximization ◽

Design Methodology ◽

Lattice Models ◽

Employee Stock Options ◽

Content Type ◽

Early Exercise ◽

Merton Model ◽

Black Scholes ◽

Computationally Intensive ◽

The Cost

Purpose – More than 80 percent of S&P 500 firms that issue ESOs use the Black-Scholes-Merton (BSM) model and substitute the estimated average term for the contractual expiration to calculate ESO expense. This simplification systematically overprices ESOs, which worsens as the stock's volatility increases. The purpose of this paper is to present a modification of the BSM model to explicitly incorporate the rates of forfeiture pre- and post-vesting and the rate of early exercise. Design/methodology/approach – The paper demonstrates the model's usefulness by employing historical exercise and forfeiture data for 127 separate ESO grants and 1.31 billion ESOs to calculate the exercise and forfeiture parameters and value ESOs for nine firms. Findings – The modified BSM model is just as accurate but easier to use than the more computationally intensive utility maximization and trinomial lattice models, and it avoids the ASC 718 BSM model's overpricing bias. Originality/value – If firms prefer the BSM model over more mathematically elegant alternatives, they should at least use a BSM model that is free of overpricing bias.

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Dot.com or Dot.bomb? The Unpleasant Tax Surprise of Stock Options in a Volatile Market

Issues in Accounting Education ◽

10.2308/iace.2003.18.4.385 ◽

2003 ◽

Vol 18 (4) ◽

pp. 385-395 ◽

Cited By ~ 5

Author(s):

Shelley C. Rhoades-Catanach

Keyword(s):

Stock Market ◽

Stock Options ◽

Stock Option ◽

Financial Impact ◽

Employee Stock Options ◽

Stock Market Crash ◽

Employee Stock Option ◽

Tax Deductions ◽

Substantial Decline ◽

Option Compensation

This case explores the tax treatment of employee stock options as well as associated tax- and financial-planning issues. The number of employee stock option plans and related option grants has increased dramatically in the last decade. Today, senior management and rank-and-file workers alike often own substantial numbers of options and shares of employer stock acquired through the exercise of options. While these holdings can be valuable forms of compensation, exercising options also can be costly and risky. Early in 2000, following the stock market boom and its substantial decline later that same year, many employees who exercised options while the equity markets were at record highs were left with large tax bills. In some cases, the taxes owed exceeded the value of the optioned stock at year-end. This case details the tax and financial impact of option exercise on one employee that chose to retain optioned stock during the stock market crash of 2000. The educational objectives of the case include: (1) becoming familiar with the tax and financial aspects of compensatory stock options, (2) identifying the risks and rewards of option grant and exercise, (3) quantifying the cash inflows and outflows associated with stock options and their tax consequences, and (4) planning to maximize the after-tax value of stock option compensation. The case also discusses the tax treatment of options from the employer's perspective and the policy issues associated with tax deductions for option exercise.

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Congressional Intervention in the Standard-Setting Process: An Analysis of the Stock Option Accounting Reform Act of 2004

Accounting Horizons ◽

10.2308/acch.2007.21.1.1 ◽

2007 ◽

Vol 21 (1) ◽

pp. 1-22 ◽

Cited By ~ 30

Author(s):

David B. Farber ◽

Marilyn F. Johnson ◽

Kathy R. Petroni

Keyword(s):

Stock Options ◽

Political Action ◽

Fair Value ◽

Stock Option ◽

Financial Accounting Standards Board ◽

Employee Stock Option ◽

Setting Process ◽

Action Committee ◽

The Cost ◽

The Impact

We examine H.R. 3574, the Stock Option Accounting Reform Act of 2004 (the Act), which sought to prevent the Financial Accounting Standards Board (FASB) from requiring the expensing of employee stock options at fair value. We find that employee stock option expense under the Act would be approximately 2 percent of what it would be under the FASB's preferred method. We also find that House members supporting the Act were more likely to be Republican, to be conservative, and to have received larger Political Action Committee (PAC) contributions. Finally, the larger the impact of H.R. 3574 on the amount of stock option expense reported by the firm for employees who are not top-five executives, the more contributions the firm's PAC made to House members and to members of the committee that approved the Act. This result suggests that corporate opposition to the mandatory expensing of stock options at fair value is not driven solely by concerns of top-five executives about the cost of recognizing their own options.

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The Value-Relevance Of Stock-Based Employee Compensation Disclosures

Journal of Applied Business Research (JABR) ◽

10.19030/jabr.v17i2.2077 ◽

2011 ◽

Vol 17 (2) ◽

Cited By ~ 8

Author(s):

Lynn Rees ◽

David M. Stott

Keyword(s):

Firm Value ◽

Stock Options ◽

Value Relevance ◽

Positive Association ◽

Fair Value ◽

Stock Option ◽

Business Community ◽

Employee Stock Options ◽

Employee Compensation ◽

Employee Stock Option

This study employs pro-forma company footnote disclosures to assess the value-relevance of employee stock option compensation expense using the fair value method as stipulated by Statement of Financial Accounting Standard No. 123.  The study is motivated by the controversy surrounding the issue of accounting for employee stock options and the countervailing effects of issuing stock options on firm value.  Although accounting regulators and the business community agree that employee stock options have value and therefore, are a form of compensation, critics of the FASB’s proposed fair value method of accounting for employee stock options argue that measuring the compensation expense using contemporary models will result in unreliable and meaningless measures.  Moreover, the expected future benefits from granting stock options suggest that this form of employee compensation is not a typical expense.  We find a significant association between the disclosed compensation expense using the fair value method and firm value that is in the opposite direction from other income statement expenses.  This result implies that the disclosed employee stock option expense is a value-relevant measure and the incentives derived from employee stock option plans provide value-increasing benefits to the firm.  In addition, we find the positive association between the employee stock option expense and firm value is greater for firms with more growth opportunities.

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EDGAR Extraction System: An Automated Approach to Analyze Employee Stock Option Disclosures

Journal of Information Systems ◽

10.2308/jis.2006.20.2.119 ◽

2006 ◽

Vol 20 (2) ◽

pp. 119-142 ◽

Cited By ~ 8

Author(s):

Gerry H. Grant ◽

Sumali J. Conlon

Keyword(s):

Stock Options ◽

Financial Statements ◽

Relevant Information ◽

Stock Option ◽

Financial Statement ◽

Automated System ◽

Extraction System ◽

Specific Information ◽

Employee Stock Options ◽

Employee Stock Option

Past alternative accounting choices and new accounting standards for stock options have hindered analysts' ability to compare corporate financial statements. Financial analysts need specific information about stock options in order to accurately assess the financial position of companies. Finding this information is often a tedious task. The SEC's EDGAR database is the richest source of financial statement information on the Web. However, the information is stored in text or HTML files making it difficult to search and extract data. Information Extraction (IE), the process of finding and extracting useful information in unstructured text, can effectively help users find vital financial information. This paper examines the development and use of the EDGAR Extraction System (EES), a customized, automated system that extracts relevant information about employee stock options from financial statement disclosure notes on the EDGAR database.

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Cross-Border Taxation of Employee Stock Options

The ATA Journal of Legal Tax Research ◽

10.2308/jltr.2006.4.1.59 ◽

2006 ◽

Vol 4 (1) ◽

pp. 59-75 ◽

Cited By ~ 1

Author(s):

Cherie J. Hennig ◽

Ningkun Wang ◽

Xiaoli Yuan

Keyword(s):

Stock Options ◽

Stock Option ◽

Tax Planning ◽

Current Status ◽

Employee Stock Options ◽

Republic Of China ◽

Employee Stock Option ◽

Cross Border ◽

Employer Perspective ◽

The U.S

The complexity of the taxation of employee stock options is escalated in a cross-border context. It is important to understand multi-jurisdictional tax differences from both the employee and employer perspective in order to avoid unnecessary tax exposure and liability. The current status of the taxation of employee stock option plans in the U.S. and the People's Republic of China is used to illustrate multi-jurisdictional taxation issues. Careful, prospective tax planning can significantly reduce an employee's cross-border tax liability.

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The Cost of Equity Implications of Accounting for Employee Stock Options

SSRN Electronic Journal ◽

10.2139/ssrn.2378952 ◽

2014 ◽

Author(s):

Zining Li ◽

Wendy M. Wilson ◽

Suning Zhang

Keyword(s):

Stock Options ◽

Employee Stock Options ◽

Cost Of Equity ◽

The Cost

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Discretion in Financial Reporting: The Voluntary Adoption of Fair Value Accounting for Employee Stock Options

Accounting Horizons ◽

10.2308/acch.2004.18.2.97 ◽

2004 ◽

Vol 18 (2) ◽

pp. 97-108 ◽

Cited By ~ 18

Author(s):

Dahlia Robinson ◽

Diane Burton

Keyword(s):

Financial Reporting ◽

Fair Value ◽

Stock Option ◽

Employee Stock Options ◽

Market Returns ◽

Employee Stock Option ◽

Accounting Reports ◽

Voluntary Adoption ◽

The Impact ◽

Is Value

This paper investigates the market reaction to announcements by firms of their decision to adopt the fair value provisions of SFAS No. 123 in accounting for their employee stock option (ESO) expense. Additionally, this paper examines ESO usage and expense of adopting firms and compares the impact of the expense on profitability measures for adopting firms relative to a matched set of control firms. We find a positive and significant abnormal return in the three days around the adoption announcements, suggesting that the decision to expense using the fair value method is value relevant. The positive abnormal announcement returns are mainly attributable to the earlier announcements, consistent with early announcements serving as a credible signal of a commitment to transparency in financial reporting. We find evidence that in the three years prior to the announcement year, adopting firms report significantly higher earnings than control firms yet fail to earn higher market returns, suggesting that adopters stand to benefit the most by improving the market's perception of their accounting reports. We also find that ESO usage, ESO expense, and the impact of ESO expense on profitability are significantly lower for adopters relative to control firms, although the impact of ESO expense is economically significant for 43 percent of the adopters.

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