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

2002 ◽  
Vol 77 (3) ◽  
pp. 627-652 ◽  
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.

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

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.

scholarly journals VALUATION OF EMPLOYEE RELOAD OPTIONS USING UTILITY MAXIMIZATION APPROACH

2005 ◽  
Vol 08 (05) ◽  
pp. 659-674 ◽  
Author(s):  
KA WO LAU ◽  
YUE KUEN KWOK
Keyword(s):  
Risk Aversion ◽  
Stock Options ◽  
Utility Maximization ◽  
Stock Option ◽  
Employee Stock Options ◽  
Employee Stock Option ◽  
General Utility ◽  
Black Scholes ◽  
The Difference ◽  
The Cost

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.

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

2004 ◽  
Vol 18 (2) ◽  
pp. 97-108 ◽  
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.

SFAS No. 123 Disclosures and Discounted Cash Flow Valuation

2000 ◽  
Vol 14 (2) ◽  
pp. 169-189 ◽  
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.

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

2003 ◽  
Vol 18 (4) ◽  
pp. 385-395 ◽  
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.

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

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.

scholarly journals Employee Stock Options Or Tax Nightmares

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.

scholarly journals The Value-Relevance Of Stock-Based Employee Compensation Disclosures

2011 ◽  
Vol 17 (2) ◽  
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

<p class="MsoNormal" style="text-align: justify; margin: 0in 37.8pt 0pt 0.5in;"><span style="mso-bidi-font-style: italic;"><span style="font-size: x-small;"><span style="font-family: Batang;">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.<span style="mso-spacerun: yes;">&nbsp; </span>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.<span style="mso-spacerun: yes;">&nbsp; </span>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&rsquo;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.<span style="mso-spacerun: yes;">&nbsp; </span>Moreover, the expected future benefits from granting stock options suggest that this form of employee compensation is not a typical expense.<span style="mso-spacerun: yes;">&nbsp; </span>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.<span style="mso-spacerun: yes;">&nbsp; </span>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.<span style="mso-spacerun: yes;">&nbsp; </span>In addition, we find the positive association between the employee stock option expense and firm value is greater for firms with more growth opportunities.</span></span></span></p>

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

2006 ◽  
Vol 20 (2) ◽  
pp. 119-142 ◽  
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.

Cross-Border Taxation of Employee Stock Options

2006 ◽  
Vol 4 (1) ◽  
pp. 59-75 ◽  
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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