Employee Stock Options And Diluted Earnings Per Share: An Extension

Firms must currently apply the fair value method in determining the amount of employee compensation incurred in the case of employee stock options. The amount of such compensation is required to be measured as fair value of the equity instrument at the grant date, with compensation expense recognized over the service period under the straight-line method. This compensation expense affects the numerator for purposes of calculating earnings per share (EPS) under generally accepted accounting principles (GAAP). Current GAAP also requires that for purposes of calculating diluted EPS, the treasury stock method be applied where the assumed proceeds from exercise of the optioned shares is used to purchase shares of the firms stock at its average market price of the earnings period. These incremental shares increase the denominator for purposes of calculating diluted EPS. These requirements are consistent across the pronouncements of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). This study extends the work of Doran (2005) where a single period model was assumed and found: 1. Application of the fair value method does not double count the impact of compensation recognized, and 2. Applying the treasury stock method where shares are assumed purchased at the average for the period price (instead of end of year price) understates the number of incremental shares (the denominator), which overstates diluted EPS. This paper employs a simple multi period model that assumes a risk free environment with complete certainty in testing the accuracy of GAAP compliant diluted EPS in the case of employee stock options. Consistent with Doran (2005) the results here again indicate that assuming purchase of treasury shares at their average market price of the earnings period understates the EPS denominator. The results of this study also indicate that the reported employee compensation expense is understated. The observed cause of this numerator error is treating the payment for the option (employee service) as if it was received in full at the grant date - as a lump sum (like inventory or some other asset), rather than being received ratably over the employee service period as an annuity. Each of these findings contributes to the observed overstatement of diluted EPS. Correct diluted EPS is observed when the employee service is treated as being received ratably over the service period, and the shares assumed purchased as treasury stock are acquired at the higher period ending market price. The amount of diluted EPS overstatement under both FASB and IASB standards is directly related to the length of the term of the option.

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A Note On Accounting For Employee Stock Options When Reporting Diluted Earnings Per Share Under The Treasury Stock Method

Journal of Business & Economics Research (JBER) ◽

10.19030/jber.v6i10.2477 ◽

2011 ◽

Vol 6 (10) ◽

Author(s):

David T. Doran

Keyword(s):

Stock Options ◽

A Priori ◽

Market Price ◽

Accounting Standards ◽

Fair Value ◽

Financial Accounting ◽

Employee Stock Options ◽

Financial Accounting Standards Board ◽

Earnings Per Share ◽

Free Environment

Firms must currently apply the fair value method in determining the amount of employee compensation incurred in the case of employee stock options.  Current GAAP also requires that for purposes of calculating diluted earnings per share (EPS), the treasury stock method be applied where the assumed proceeds from exercise of the optioned shares is used to purchase shares of the firm’s stock at its average market price of the earnings period.  These incremental shares increase the denominator for purposes of calculating diluted EPS.  These requirements are consistent across the pronouncements of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).  This study extends the work of Doran (2005) and Doran (2008).  These previous studies found that applying the treasury stock method where shares are assumed purchased at the average for the period price (instead of end of year price) understates the number of incremental shares (the denominator), which overstates diluted EPS.  However, these previous works assumed that no shares were actually purchased for the treasury during the earnings period.  The FASB indicates one reason that the average for the period price is appropriate is because if treasury shares purchases were to occur, “the shares would be purchased at various prices, not at the price at the end of the period.”  This study tests the notion that the average for the period price is appropriate under circumstances where the firm actually purchases shares for the treasury at its average market price during the earnings period.  This paper employs a simple one period model that assumes a risk free environment with complete certainty.  The model allows comparison of computed EPS with an a priori known, correct amount.  Consistent with Doran (2005) and Doran (2008), the results here again indicate that assuming purchase of treasury shares at their average market price of the earnings period understates the EPS denominator which results in EPS overstatement.  Correct diluted EPS is derived when the shares assumed purchased under the treasury stock method are acquired at the higher period ending market price.

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Diluted Earnings Per Share Overstatement Bias: Including Unrecognized Employee Compensation In Proceeds From Assumed Exercise Of Employee Stock Options Under The Treasury Stock Method

Journal of Applied Business Research (JABR) ◽

10.19030/jabr.v29i6.8204 ◽

2013 ◽

Vol 29 (6) ◽

pp. 1657

Author(s):

David T. Doran

Keyword(s):

Financial Reporting ◽

Stock Price ◽

Stock Options ◽

Fair Value ◽

Stock Option ◽

Employee Stock Options ◽

Employee Compensation ◽

Earnings Per Share ◽

Service Period ◽

Free Environment

Generally accepted accounting principles (GAAP) require firms to recognize compensation expense under the fair value method in the case of employee stock options. Straight line amortization of the options grant date fair value must be recognized as expense over the service period which decreases the earnings per share numerator. For diluted earnings per share (EPS), GAAP requires using the treasury stock method, where proceeds from assumed stock option exercise is used to purchase treasury shares at the average for the period price. Exercise proceeds include the exercise price plus unrecognized future employee compensation. For profitable firms, exercise is assumed if dilutive - more shares are assumed issued than are reacquired for the treasury which increases the diluted EPS denominator. These requirements are consistent across US GAAP and International Financial Reporting Standards. This paper tests whether including unrecognized employee compensation in proceeds from the assumed exercise of employee stock options under the treasury stock method is appropriate. A simple multi period model that assumes a risk free environment with complete certainty is applied. This study contributes to the literature by demonstrating that future unrecognized employee compensation should not be included in proceeds from the assumed exercise of stock options under the treasury stock method. Doing so consistently causes diluted EPS overstatement, and in certain instances causes assumed exercise of in the money options to be antidilutive, which results in complete exclusion from the diluted EPS calculation. This research extends the employee stock option work of Doran (2005 and 2008) that found: 1) Compensation expense recognized over the employee service period should equal the periodic annuity amount that provides the options grant date fair value, and 2) Treasury shares should be assumed purchased at the higher end of period stock price.

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Employee Stock Options And Diluted Earnings Per Share

Journal of Business & Economics Research (JBER) ◽

10.19030/jber.v3i11.2828 ◽

2011 ◽

Vol 3 (11) ◽

Author(s):

David T. Doran

Keyword(s):

Stock Price ◽

Stock Options ◽

Intrinsic Value ◽

Market Price ◽

Fair Value ◽

Employee Stock Options ◽

Research Support ◽

Earnings Per Share ◽

Free Environment ◽

Period Model

At the time of this writing, SFAS No.123 (1995) prescribes GAAP in accounting for employee stock options. It allows firms to choose either the intrinsic or fair value method in determining the amount of compensation expense recognized for employee stock options. The choice of method affects the numerator of the earnings per share (EPS) calculation. The FASB recently issued a revised SFAS No. 123 (2004) which will require uniform application of the fair value method. GAAP also requires that the denominator for the diluted EPS calculation be increased for incremental shares under the treasury stock method. SFAS 128 requires the treasury stock method be applied where the proceeds from the assumed exercise of options are used to acquire shares of the firm’s outstanding stock at the average market price for the period. Previous to SFAS No. 128, APB Opinion No. 15 required that the higher of average or period ending stock price be used in determining the number of shares reacquired with the proceeds from the assumed exercise of stock options. This paper develops a simple one period model that assumes a risk free environment with complete certainty conditions in testing the accuracy of EPS calculated under GAAP using the fair value method vs. the intrinsic value method. The results indicate that EPS reported under the intrinsic value method are overstated, and further indicate that a combination of both the fair value method and the treasury stock method is needed in calculating diluted EPS. This fair value and treasury stock method combination is shown to not “double count” the stock option’s impact upon EPS. The results also indicate a slight misstatement of diluted EPS under the fair value method when applying the treasury stock method requirements of SFAS No. 128. Correct EPS results when shares are assumed reacquired for the treasury at the higher year ending price, consistent with superseded APB 15. However, the diluted EPS misstatement is so slight that the FASB’s rationale for always requiring the use of average period price seems likely to be justified. The findings of this research support the requirements of SFAS No. 123 (revised 2004) and SFAS No. 128.

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An Alternative Method Of Accounting For Stock Options

Journal of Applied Business Research (JABR) ◽

10.19030/jabr.v30i2.8415 ◽

2014 ◽

Vol 30 (2) ◽

pp. 439

Author(s):

Thomas Smith ◽

Adrian Valencia ◽

Ara Volkan

Keyword(s):

Stock Options ◽

Intrinsic Value ◽

Market Price ◽

Fair Value ◽

Financial Accounting ◽

Employee Stock Options ◽

Financial Accounting Standards Board ◽

Exercise Price ◽

The Difference ◽

The Impact

Currently, the grant date fair value of employee stock options is expensed over the vesting period. Our study introduces a new valuation approach for stock options and examines the impact of this change on earning per share (EPS) for a sample of firms over the period 2002-2011. The new valuation approach provides data useful to the Financial Accounting Standards Board (FASB) as it determines whether to revise the current option accounting rules. Under the proposed approach, options are valued at their intrinsic value on the grant date (i.e., the opportunity cost or the economic promise associated with the difference between the exercise price of the option and the market price of the stock at each measurement date) and further revalued each reporting date until the options are exercised.

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The Impact of IFRS 2 "Share-Based Payment" on Malaysian Companies

Review of Pacific Basin Financial Markets and Policies ◽

10.1142/s0219091510002025 ◽

2010 ◽

Vol 13 (03) ◽

pp. 449-468 ◽

Cited By ~ 7

Author(s):

Ruhaya Atan ◽

Nur Syuhada Jasni ◽

Yousef Shahwan

Keyword(s):

Stock Options ◽

Negative Relationship ◽

Fair Value ◽

Employee Stock Options ◽

Accounting Standard ◽

Corporate Scandals ◽

Black Scholes ◽

Compensation Plan ◽

The Impact ◽

International Accounting Standard

In the wake of corporate scandals and excessive stock options compensation, International Accounting Standard Board (IASB) has introduced a new accounting standard, IIFRS 2 Share-based Payments. The scope of the standard extends beyond payments to employees, but for the purpose of this study, the focus is only on 'employee stock options'. IIFRS 2 requires a fair value of stock options records calculated on grant date, and recognized as compensation expenses over vesting periods. Prior to the introduction of IIFRS 2, stock options were not recognized and were only disclosed in the notes to the accounts. In Malaysia, the standard is mandatory for all companies listed on or after January 1, 2006. This study assumes the requirement existed in 2003. This study examines the impact of stock options expenses from 2003 to 2005, on the top 100 Malaysian companies. The three year observations show at least 24% of the sample exceeds the 5% materiality threshold on diluted EPS. The sectors that are impacted the most are the Trade/Service and Finance sectors. From the multiple-regression test, this study finds that fair value of stock options have a negative relationship with dividend yields (input of the Black-Scholes Merton (BSM) Model). Most companies in the sample are found to pay dividends and grant stock options at the same time. Therefore, this study suggests that companies need to restructure their compensation plan thus balancing the stock options granted and dividends paid in the future.

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An Evaluation Of Fair Value Accounting For Employee Stock Options

International Business & Economics Research Journal (IBER) ◽

10.19030/iber.v11i7.7068 ◽

2012 ◽

Vol 11 (7) ◽

pp. 821

Author(s):

Harry Howe ◽

Jeffrey W. Lippitt

Keyword(s):

Stock Options ◽

Simulation Analysis ◽

Accounting Standards ◽

Fair Value ◽

Measurement Properties ◽

Employee Stock Options ◽

Fair Value Accounting ◽

Wide Range ◽

Cash Cost

This paper employs static and simulation analysis to consider the measurement properties of the currently active accounting standards for reporting compensation expense related to Employee Stock Options. We find that under a wide range of plausible scenarios the reported expense significantly understates the cash cost incurred by the entity at exercise. The paper includes a discussion of implications for practice and standards setters.

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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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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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The Effects of Employee Stock Options on Credit Ratings

The Accounting Review ◽

10.2308/accr.2008.83.5.1273 ◽

2008 ◽

Vol 83 (5) ◽

pp. 1273-1314 ◽

Cited By ~ 22

Author(s):

Yen-Jung Lee

Keyword(s):

Stock Options ◽

Credit Rating ◽

Credit Ratings ◽

Fair Value ◽

Cash Flows ◽

Share Repurchases ◽

Credit Rating Agencies ◽

Employee Stock Options ◽

Rating Agencies ◽

Unfavorable Effect

ABSTRACT: This paper examines whether outstanding employee stock options (ESOs), which represent the firm’s contractual obligation to deliver shares upon ESO exercise, affect firms’ credit ratings. I hypothesize that outstanding ESOs play two information roles—(1) suggesting equity infusion, and (2) predicting share repurchases—that help credit-rating agencies evaluate the issuing company’s debt service ability. Consistent with these hypothesized roles, results indicate that the present values of expected cash proceeds and tax benefits from ESO exercise have favorable effects on credit ratings. In contrast, the present value of the expected cost of ESO-related share repurchases has an unfavorable effect on credit ratings and this unfavorable effect is more pronounced for firms with a greater tendency to repurchase shares. The after-tax fair value of outstanding ESOs, which summarizes the effects of the above three ESO-related cash flows, is negatively associated with credit ratings. Taken together, these findings are consistent with credit-rating agencies incorporating the information conveyed by outstanding ESOs regarding potential equity infusion and ESO-related repurchases in their credit risk assessments and assigning lower credit ratings to firms with greater values of outstanding ESOs.

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