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

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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Employee Stock Options And Diluted Earnings Per Share: An Extension

International Business & Economics Research Journal (IBER) ◽

10.19030/iber.v7i2.3218 ◽

2011 ◽

Vol 7 (2) ◽

Author(s):

David T. Doran

Keyword(s):

Stock Options ◽

Market Price ◽

Accounting Standards ◽

Fair Value ◽

Employee Stock Options ◽

Employee Compensation ◽

Earnings Per Share ◽

Service Period ◽

The Impact ◽

Period Model

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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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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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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Discretionary Reporting of Stock Options by IPO Firms

Accounting Horizons ◽

10.2308/acch.2005.19.4.223 ◽

2005 ◽

Vol 19 (4) ◽

pp. 223-236 ◽

Cited By ~ 2

Author(s):

Joseph D. Beams ◽

Anthony J. Amoruso ◽

Frederick M. Richardson

Keyword(s):

Initial Public Offering ◽

Stock Price ◽

Stock Options ◽

Peer Group ◽

Price Volatility ◽

Fair Value ◽

Employee Stock Options ◽

Public Companies ◽

Option Values ◽

Public Offering

The revision of SFAS No. 123 (SFAS No. 123R, FASB 2004) requires companies to recognize the fair value of employee stock options. In addition, nonpublic companies will no longer be permitted to assume stock price volatility of zero when calculating the fair value of their stock options. This study finds that the zero volatility assumption allowed under the original version of SFAS No. 123 (FASB 1995) resulted in an average estimated fair value of options that was $1.06 (40 percent) less than the fair value calculated using a peer group volatility estimate for firms undergoing an initial public offering (IPO). However, IPO firms that estimated their volatility underreported option values by an even larger magnitude than the group using the zero volatility assumption. Perhaps these firms reported a downward-biased estimate of volatility to inhibit analysts from computing option values using more reasonable volatility estimates. Contrary to the findings for public companies, we find that a large percentage of sample firms issued in-the-money options prior to going public. Following the IPO, only a small portion of firms issued in-the-money options. The concerns regarding recognizing option expense may be less important than the benefits of granting in-the-money options for IPO firms.

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Using Sectoral Indexes to Discount the Exercise Price of Employee Stock Options

Folia Oeconomica Stetinensia ◽

10.1515/foli-2016-0010 ◽

2016 ◽

Vol 16 (1) ◽

pp. 174-185

Author(s):

Agnieszka Majewska

Keyword(s):

Stock Price ◽

Stock Options ◽

Stock Exchange ◽

Intrinsic Value ◽

Stock Option ◽

Annual Reports ◽

Variable Component ◽

Employee Stock Options ◽

Strike Price ◽

Exercise Price

Abstract Employee stock options (ESOs) are an instrument in compensating top management of corporations. In the literature, they are described as a variable component of remuneration of a long-term character (Borkowska, 2012). There are six characteristic elements of the ESO: a grant date, the ESO plan duration, employees entitled to receive options, vesting criteria, a vesting period, and an exercise price. The article refers to the exercise price. The remuneration of employees is determined by the option’s intrinsic value, i.e. the difference between the current stock price and the exercise price. This difference affects the costs incurred by a company in relation with their incentive stock option plan. In this connection, the exercise price of stock options needs to be analysed. The literature shows that usually the strike price is equal to the stock market’s value at the time the option is granted. The options issued with an exercise price equal to the market value of the company’s stock on the date of the grant usually lead to at-the-money options. Walker (2009) mentions that almost all options issued by US firms have been such type of options. Hence, the options with exercise prices less than the prices of the underlying assets have been rarely observed. One of the solutions can be discounting the exercise price by using sectoral indexes, which are sensitive to changes on a particular market. The purpose of this paper is to address several aspects of specifying the exercise price in ESOs. The research shows how sector indexes can be used to discount it. Using sectoral indexes in determining the exercise price can partly limit the unreasonably high profits from the ESO. The literature does not provide ready-made formulas of exercise prices based on specific variables. The aim of the research is to present and apply the formula of the exercise prices in which sectoral indices are used to discount. The data are from the Warsaw Stock Exchange (WSE) and include those companies that revealed the information concerning their incentive programs in 1999–2013. The relevant data come from annual reports, current reports, supervisory boards’ resolutions, and press announcements.

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Employee Stock Options Or Tax Nightmares

International Business & Economics Research Journal (IBER) ◽

10.19030/iber.v1i1.3879 ◽

2011 ◽

Vol 1 (1) ◽

Author(s):

Raj Kiani ◽

Dwight Call ◽

M. Sangeladji

Keyword(s):

Stock Price ◽

Stock Options ◽

Effective Means ◽

Stock Option ◽

High Tech ◽

Employee Stock Options ◽

Highly Qualified ◽

The Past ◽

Cash Compensation ◽

Set Up

In the past several years, many companies, especially in the high-tech, have used incentive stock options as effective means of attracting and maintaining highly qualified employees. With properly designed employees stock options, companies have been able to compensate highly paid executives with a little or no cash out flow. Accepting stock options in lieu of cash compensation has allowed employees to postpone tax on their compensations and to convert the ordinary income to the capital gain income through a later exercise and the sales of their stock options. These benefits can be achieved, if companies set up the stock options properly and employees apply them correctly. Otherwise, employees may get stuck in incentive stock option tax traps depending on the type of stock options. One tax trap related to the Incentive Stock Option (ISO) is a danger of an Alternative Minimum Tax (AMT). The tax trap related to Nonqualified Stock Option (NQSO) is the possibility of a phantom profit. This profit, even though the stock may not have been sold yet by the employees, must be reported by employer to the Internal Revenue Service through employees W-2 form in the year the options are granted or exercised, depending on the prevailing situation. Employees, who exercise this type of options and keep the purchased stocks, may risk watching the stock price decline but still having to pay taxes based on their paper profit.

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Accounting For Employee Stock Options As Contingencies

Journal of Applied Business Research (JABR) ◽

10.19030/jabr.v10i1.5959 ◽

2011 ◽

Vol 10 (1) ◽

pp. 19 ◽

Cited By ~ 1

Author(s):

Albert Y. Lew ◽

Joseph F. Schirger

Keyword(s):

Financial Reporting ◽

Stock Options ◽

Stock Option ◽

Employee Stock Options ◽

Accounting Profession ◽

Accounting Practice ◽

Accounting Principles ◽

New Framework

The accounting profession has long attempted to improve the disclosure of compensatory stock option information in financial reporting. While evidence of inconsistent practice has been publicized and acknowledged, suggestions for readjustment center largely around technicalities. The purpose of this article is to: (1) identify the inherent weakness of existing accounting principles on stock options, and (2) propose a new framework to account for employee stock options so that conflicting issues can be resolved in theory as well as in accounting practice.

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