The accounting rules for employee stock options have received a
great deal of attention in the press throughout the past several
months. Those in favor of expensing the options-something not
currently required by the Financial Accounting Standards Board
(FASB)-argue that options are a form of compensation and
therefore should be expensed.
Some argue that because options were not expensed, stock
prices were artificially high and contributed to the recently burst
"bubble" in the market. They argue that these artificially high
stock prices "spawned Enron, WorldCom, and a hundred more corporate
debacles like them that have yet to even surface…."
[1] In response
to such concerns, Senators John McCain (R-AZ) and Carl Levin (D-MI)
have sponsored S. 1940, which would require companies to
expense stock options or forfeit their tax deduction. Critics of
mandated expensing of employee stock options (for the most part,
companies in the technology sector) argue that expensing the
options will depress earnings and thus make it more difficult to
raise capital and retain employees. This paper argues that both
opponents and advocates of the proposal have ignored important
issues that underlie employee stock option accounting and that
Congress should not be micromanaging corporations' accounting
practices. Additionally, the paper presents statistical evidence
that, provided there is full disclosure, the market is
indifferent to the accounting rules for employee stock options.
Consideration of expensing stock options should take into
account the following facts.
- There have
been virtually no rigorous studies of the relevance of this
accounting rule. There are two explicit costs of
employee stock options: the cost of acquiring the shares that
will be granted and the cost associated with diluting the shares of
existing shareholders. Since both of these costs are accounted for
on corporations' financial statements, mandating that the options
be expensed appears unnecessary. In spite of the enormous amount of
media attention recently given to this issue, we have found no
empirical studies that directly test for the relevance of the
proposed employee stock option accounting rules.
- Investors appear indifferent to the accounting rule for stock
options. Our analysis suggests that, provided there is adequate
disclosure, the choice of accounting methods for employee stock
options is irrelevant to investors. Using six separate
announcement dates, all of which contained important
information regarding the status of the proposed accounting
rules, our tests indicate that the market is not concerned with
which rule- the fair value method or the intrinsic value method-is
chosen.
- Expensing may actually increase the use of employee stock
options. It is possible that forcing companies to expense their
employee stock options could lead to an increase in their usage.
Profitable firms with lower amounts of employee stock options
outstanding would be able to reduce their taxes more easily. For
the expensing requirement to curb option use, at least two
conditions must be present. First, the market would have to be
incapable of determining how many options firms had
previously granted under the old rules. Second, investors
would have to be incapable of distinguishing between cash and
non-cash expenses. Our study provides evidence that neither of
these conditions exists.
History of the Issue
The question of whether or not to expense employee stock options
has been debated since the early 1970s. In 1972, the Accounting
Principles Board (APB) adopted an accounting method - APB No.
25-that did not require option expensing and is still used
today. The main reason that APB No. 25 did not require option
expensing was that a reasonable method of valuing the options did
not exist.[2] In 1973, a
model that still serves as one of the most widely used methods for
valuing traded stock options-the Black-Scholes model- was published
in the Journal of Political Economy.[3] Through the
years, the Black-Scholes model and a number of other models have
attracted increased attention with a rise in the use of employee
stock options.Companies began issuing employee stock options to
their top executives more frequently in the mid- to late 1970s; by
the early 1990s, many were actively issuing employee stock options
to rank-and-file employees as well. By June 30, 1993, the use of
employee stock options had become so widespread[4] that the
Financial Accounting Standards Board issued a proposed rule
requiring that employee stock options be expensed.
That proposal created a storm of debate and congressional lobbying
that ultimately forced the FASB to rescind the proposed rule in
late 1994. During this debate, as has been the case recently, the
typical arguments in favor of expensing centered on the abuse
of options and the exploitation of tax loopholes. In 1994, Senator
Carl Levin introduced a bill that was designed to curb the use of
employee stock options.
[5] Politicians
are now using concerns regarding recent corporate scandals to renew
the attack on employee stock options. In a recent speech on the
Senate floor, Senator Levin, co-sponsor of S. 1940, claimed that
options were "a driving force behind management decisions at Enron
that focused on increasing Enron's stock price rather than the
solid growth of the company."
[6] A spectrum
of opinions have now been issued on this matter. Some have argued
that options should be expensed because they would otherwise be a
cost that companies could hide. Others have argued that they should
not be expensed because doing so would lead to artificially
depressed earnings. Still others have linked employee stock
options directly to corporate scandals at Enron and other firms.
Amid this debate, the public can easily be confused about
the value or dangers of employee stock options-especially given the
technical nature of the accounting rules. In reality, employee
stock options are simply a cost-effective way to compensate
employees. Rather than formulating policies on the basis of largely
untested notions,[7] it would be
better to conduct a careful examination of how employee stock
options function.
How Employee Stock Options Work
The two key dates involved in analyzing the effect of an option
on an employee's income are its grant date and its exercise date.
The grant date is the date the option is awarded to the employee.
The exercise date is the date the employee can exercise the right
to "use" the option.
Consider, for example, the following scenario. On January 1,
company ABC grants an employee an option to buy one share of the
company's stock. This option has a term of five years and an
exercise price of $20. That is, on December 31, five years later,
the employee may exercise the option to buy one share of company
ABC's stock for $20. If, at the exercise date, the company's stock
is selling on the market for less than $20, the employee can simply
allow the option to expire. On the other hand, if the stock is
selling for more than $20, the employee can make a "profit." For
example, if the company's stock is selling for $30, the employee
can buy a share for $20 and sell it for $30, thus gaining $10 in
income. Even though nearly all employee stock option plans prohibit
the employee from selling these shares for at least several years,
the Internal Revenue Service requires the employee to pay taxes on
the gain at the exercise date.
Since the firm has given the employee a form of compensation, it
is allowed to take a tax deduction on the employee's gain-just as
it would for normal salary expenses.[8] However, the
source of this compensation is very different from normal wages and
consequently has contributed to the spread of misinformation in the
media. The stock that is awarded to the employee can either be
purchased on the open market or taken out of treasury stock.[9] Treasury
stock can be thought of as a "vault" where the firm holds shares of
its own stock.
When the source of the option shares is the open market, the
only cost to the firm is the cost of buying those shares-a cost
that is accounted for in the body of the financial statements. In
this case, since the number of shares on the market remains
unchanged, there is no additional cost to the existing
shareholders. Alternatively, when the source of the option shares
is "the vault," there is an additional cost to the existing
shareholders: The total number of shares on the market has been
increased, thus diluting the value of each existing share.
When the options are granted, this cost is
clearly identified in the diluted earnings per share (EPS) figure;
any amount of earnings is now divided among a larger number of
shares. For example, if a firm has $100,000 in earnings and has
10,000 shares outstanding, its EPS is $10. However, should the firm
grant an additional 1,000 shares for options, its diluted EPS would
drop to just over $9 ($100,000/11,000).
While granting employee options does not
entail any other explicit cost to a firm, some have argued that the
implicit cost of issuing these options requires that they be
expensed.
[10] To
evaluate this argument, it is helpful to examine the
difference between accounting profit and economic
profit.
Accounting profit vs. Economic
Profit
The key difference between economic profit
and accounting profit is that only economic profit measures
opportunity costs. One of the best-known examples of an opportunity
cost is the cost of equity capital.
[11] While
equity capital cost does not appear on a company's balance sheet,
investors use information in the market to estimate this
cost.
To demonstrate how equity capital cost
differs from accounting cost, assume that an entrepreneur wishes to
open a bakery and wants to use her savings ($50,000) for the
start-up costs. These savings are in a mutual fund earning 10
percent interest per year. The entrepreneur uses her savings
to start the bakery and after one year has an income statement
showing an accounting profit (Net Income) of $1,000.
[12] However,
from an economic standpoint, the baker has lost $4,000, given
that if she had simply kept her savings in the mutual fund, she
would have earned $5,000. Thus, when this opportunity cost-the cost
of taking the money out of the mutual fund-is taken into
account, the baker actually lost money, but this opportunity cost
will not show up on an accountant's report.
While the opportunity cost is easy to
identify in the above example, this sort of clarity is often not
present in the finances of a publicly traded corporation,
where capital flows in from various sources and out through various
uses. Aside from subjectivity problems, it would be
counterproductive to measure opportunity costs on accounting
statements since such costs could be construed for any and all
expenditures. For example, this would mean that when a cash bonus
is paid to an employee, rather than accounting for only the
salary expense, the firm would also have to account for losses
measured in terms of a forgone alternative use of that cash.
If all publicly traded companies reported their costs in this
manner, it would be nearly impossible to make relevant
comparisons between companies' earnings.
Nonetheless, it is sometimes argued that,
since the options could have been sold in the market, these costs
should be expensed on the income statement. Following this logic,
all income statement expenses would have to be adjusted for
their opportunity costs, and the net result would be counter to the
goal of having uniform accounting principles.
[13]Therefore, those opposed to expensing these
options have legitimate concerns. Counter to their lobbying efforts
in the past, however, many large corporations have recently
announced that they would start expensing their employee stock
options. To understand this contradictory behavior, it is
helpful to examine the exact nature of the accounting methods for
employee stock options.
Overview of The Accounting
Rules
C urrently, the Financial Accounting Standards Board allows
companies to choose which of two accounting methods they would
prefer to use- the fair value method (FAS No. 123) or the intrinsic
value method (APB No. 25). Under the intrinsic value method, which
most companies use,
[14] the options
are not reported as an expense on the income statement. Instead, a
footnote disclosure is made that includes options granted,
exercised, and outstanding, as well as restated earnings (i.e.,
restated as if the options had been expensed). Additionally,
diluted per-share figures (as described above) are listed on the
income statement, and any tax benefits at the exercise date
are reported on the income statement and the cash flow statement.
In contrast, under the fair value method,
options are reported as a compensation expense. At their grant
date, options are valued using an approved valuation model,
typically the Black- Scholes model.
[15] This
formula is one of the most complex in finance and includes the
following variables: the current price of the stock, the
exercise price of the option, an assumed risk-free rate of
return, the volatility of the stock's returns, and the time to
expiration. Even in the absence of malicious behavior, because
varying assumptions can be made as to the time to expiration
[16] and the
stock's volatility, reported Black-Scholes option values for
different firms will be to some extent incomparable. Nonetheless,
this value is then amortized over the estimated term of the
option.
For each year, the annualized portion is
charged to compensation expense with a corresponding credit to
equity. But this expense is a non-cash expense and is added back to
net income to arrive at the firm's net cash flow. Since the true
value of the option will not be known until the exercise date, an
accounting mechanism is needed to correct for any differences
in the estimated and actual values. To allow for this discrepancy,
the company accrues a deferred tax asset throughout the term of the
option. If the option value turns out to be different from the
originally estimated value, the accounts are adjusted
accordingly.
Clearly, the fair value method has the
potential to make financial statements less transparent in the
sense that additional adjustments will be needed to arrive at the
"true" earnings figure. Not only do all of the option valuation
models contain elements of subjectivity, but the typical variation
in any firm's stock price all but guarantees that some sort of
earnings adjustment will be needed at the exercise date.
In any event, the firm benefits because it
can reduce its taxable income sooner rather than later. When a firm
grants an option with a five-year term, rather than waiting for
five years for a tax benefit, it can reduce its taxable income
immediately. Even better, if the stock price at the
beginning of year five increases the likelihood that the
firm's tax benefit will be smaller than originally estimated, the
firm can issue more employee stock options. In essence, expensing
employee stock options gives firms another way to shield income
from being taxed.
While the term "shielding income" may sound
complicated, it is really just another way of saying that the firm
is able to hold on to more of its cash. It is entirely possible,
therefore, that the proposed rule to mandate expensing options
would increase rather than curb the use of employee stock options.
For the expensing requirement to curb option use-as many in the
technology sector argue it would-the market would have to be
incapable of determining the number of options issued by firms and
of distinguishing between cash and non-cash expenses.
This leads to interesting empirical
questions: whether the market already values these options and,
correspondingly, whether the accounting treatment chosen (FAS No.
123 vs. APB No. 25) matters to investors. To begin to answer these
questions, we conducted the study described below.
Methodology
Using Eventus®, an event study software, we employed an event
study methodology to examine the abnormal returns around several
dates related to employee stock option expensing. Abnormal returns
were estimated using two models: the Market Model, where returns
follow a single-factor market model, and the Market Adjusted
Returns Model. The formal statements of these models are as
follows:
Model 1 calculates the return of each stock j
at each time t, Rjt, using an Ordinary Least Squares regression
(OLS). Under the OLS procedure, stock j's return at time t is equal
to some constant, aj, plus the
return of the market at time t, Rmt, and an error term, ejt. The return
on the market uses stock j's beta, b, as the
single factor (beta is a measure of the stock's risk). The
model then uses the error term, ejt, to
represent the abnormal return for each stock j at each time t,
Ajt.
As an alternate specification, Model 2
calculates abnormal returns as the return of each stock j at each
time t, Rjt, less the return of the market at each time t Rmt. In
both models, Eventus® uses the value-weighted index from the
Center for Research in Security Prices (CRSP) as a market proxy
(this index consists of firms in CRSP with usable returns, weighted
by their market value).
Using standard event-study methodology,
statistically significant
[17] cumulative
average abnormal returns (CAAR) indicate a "response" to an event.
The CAAR is measured as follows:
This measure simply sums the abnormal returns for each stock for a
given time period. This time period is called the "event window,"
referring to a period of time around each announcement date. For
example, a -5/+5 event window examines abnormal returns for each
stock in the sample from five days prior to the announcement date
through five days after the announcement date, with "day zero"
being the event/announcement date. Over any given event window, a
positive CAAR for a sample of firms (at a significance level of at
least 90 percent) is taken to indicate a favorable response to
an event for those firms, while a negative CARR (at a 90 percent
significance level) would be viewed as a negative response to an
event.[18]
To begin, we examined responses for windows
around the dates of two formal FASB announcements: June 30,
1993, when the FASB issued a proposed rule requiring employee stock
options to be expensed, and December 14, 1994, when it withdrew the
proposed rule.
Since it is possible that the information in
the FASB announcements was public prior to the official
announcements, we performed a Westlaw search for Wall Street
Journal (WSJ) articles from January 1, 1991, to December 14, 1994,
using the search string "'stock option' and expense."
[19] This
Westlaw search revealed several news stories that could have
contributed to the information in the FASB announcements' being
public prior to the official announcement dates.
On February 5, 1993, the WSJ reported that
the Business Roundtable was trying to derail the proposal to
expense employee stock options. In this same article, it was
reported that the Business Roundtable sent a private letter to the
FASB on January 18, 1993, urging that the proposal to expense
options be modified. No other stories were found between January 1,
1991, and June 30, 1993. On April 22, 1994, the WSJ reported that
the FASB was likely to postpone its expensing proposal for at least
one year. Finally, on July 6, 1995, it was reported that, pending a
meeting one week later, the FASB would require a footnote
disclosure that restated earnings as if employee stock options
had been expensed.
Table 1 provides a summary of all the dates
studied.
[20]
Since the true cost of employee stock options
is the dilution of the value of existing shares, our samples are
based on a measure of potential dilution. Using Standard and
Poor's Compustat Database of North American publicly traded
companies, we measured the ratio of "common shares reserved for
conversion-stock options" (item #215) to common shares
outstanding.
[21] This ratio
serves as a proxy for the maximum potential dilution faced by
shareholders.
Our initial samples consisted of all the
firms in Compustat for which this ratio was available in 1992,
1993, and 1994, respectively. We then divided the full sample of
each year into quartiles based on the ratio. Therefore, the highest
quartiles for each year consist of the firms with the most stock
options (relative to common stock outstanding) and are the
most likely to be affected by the proposed FASB rules.
If option expensing is extremely important,
there should be significant differences between the responses of
the firms with the highest ratio and those with the lowest. To
investigate their responses, for each of the six dates above,
we performed event studies on the full samples as well as on the
four quartiles of each sample.
[22] While our
sample sizes vary, the full samples for each announcement date are
all over 2,500 firms. (Each sample size, along with descriptive
statistics, is listed in Table 2.)
[23]
We used 1992 year-end data for the 1993 announcement dates, 1993
year-end data for the 1994 announcement dates, and 1994 year-end
data for the 1995 announcement date. The hypotheses tested are
explained in the next section, and the subsequent section
discusses the results from measuring the CAAR for five days prior
to and for five days after each announcement date in Table 1.[24]
Hypotheses
Using the event-study methodology discussed above, there are
several hypotheses that can be tested. These hypotheses and the
responses providing support for or evidence against each one
are as follows.
HYPOTHESIS
1: The market wants employee stock options to be
expensed. Support for this hypothesis would be in the form of a
positive response on Date 1 and, generally speaking, negative
responses on Dates 2 through 6. Announcement Dates 3 and 4, both of
which preceded the official FASB announcement on Date 1, introduce
a source of ambiguity.
For instance, the information contained in Date 3 and Date 4
clearly shows that there was some public knowledge of the FASB's
intention to propose a rule requiring options to be expensed. One
view is that the signs of any responses on Date 3 and Date 4 should
match the signs of a response on Date 1. This view holds that all
three dates "announce" that FASB is considering the expensing
proposal.
Alternatively, the information in Date 3 and Date 4 could be
viewed as "announcing" that the expensing proposal is going to meet
stiff resistance and, in all likelihood, will not go into effect.
In this case, the signs on any responses of Dates 3 and 4 would be
opposite of the sign of any response on Date 1. Since resistance to
the proposed rule was clearly evident before the official
announcement of the rule, and since the rule did not go into
effect, we have taken the latter view.
Date 6 entails elements of vagueness. Most important, there is
additional information in the formal announcement issued on this
date, including the details of requiring a new footnote
disclosure. Since it lowered information costs surrounding employee
stock options, this new disclosure rule would have been likely to
elicit a positive response around Date 6. Other issues surrounding
Date 6 will be discussed below in the results section.
HYPOTHESIS
2: The market does not want employee stock options
to be expensed. Support for this hypothesis would take the
form of a negative response on Date 1 and positive responses on
Date 2 through Date 6.
HYPOTHESIS
3: The market is indifferent to this accounting
rule. Support for this hypothesis would be indicated if responses
to most of the dates in Table 1 are found to be statistically
insignificant.
Results
On the full sample of 2,666 firms for June 30, 1993 (Date 1),
when the Financial Accounting Standards Board formally announced
the proposed rule requiring employee stock options to be expensed,
both models show no statistically significant response. The
results for the quartiles around Date 1 are similar.
In both Model 1 and Model 2, there was no significant
response to the announcement in the highest, upper-middle, and
lower-middle quartiles. For the lowest quartile, Model 1 found
a positive 1.76 percent response at the 90 percent level, and
Model 2 showed no significant response. These results provide some
evidence for Hypothesis 3: that the market is indifferent
toward the accounting rule. However, since a WSJ article on
February 5, 1993, indicated that the Business Roundtable was trying
to derail the FASB's expensing proposal, it is possible that
the information contained in the Date 1 announcement was already
valued in the market (as discussed above).
The results regarding February 5, 1993 (Date 4), are similar to
those for Date 1. For the full sample of 2,551 firms for Date
4, as well as for all of the quartiles, both models show no
significant response. These results appear to favor Hypothesis 3:
that the market is indifferent to the accounting rule.
Since the WSJ article on Date 4 indicated that the Business
Roundtable had sent a private letter on January 18, 1993 (Date 5),
to the FASB, we examined Date 5 as well. For the full sample of
2,776 firms on Date 5, Model 1 revealed a positive 1.73 percent
abnormal return at the 90 percent level, and Model 2 revealed no
significant response. Both models showed that there were no
significant responses in the highest and lowest quartiles. However,
a positive response was found for the upper-middle and lower-middle
quartiles using both models (both at the 90 percent level). Given
that the highest quartiles should show a more pronounced
response than the lower quartiles, these results are somewhat
peculiar. One possible explanation for these results is that
this date, which is the date of a private letter (announced
publicly almost one month later), did not contain any
significant public information. Even if the results around
Date 5 are taken to offer some evidence for either Hypothesis 1 or
Hypothesis 2, most of the evidence thus far appears to support
Hypothesis 3: that the market is indifferent to the accounting
rule. The next date examined is December 14, 1994 (Date 2), when
the Financial Accounting Standards Board officially rescinded
the proposal that would have required option expensing. For the
full sample of 2,749 firms, there was a negative 1.33 percent
response at the 90 percent level using Model 1 and a negative 2.03
percent response at the 95 percent level using Model 2. The results
for the quartiles around Date 2, however, are mixed. Model 1 shows
that there was no significant response for the highest quartile,
while Model 2 reveals a negative 3.67 percent response (at the 99
percent level) for the highest quartile. While the upper-middle and
lower-middle quartiles all show a significant negative response
under both models, the lowest quartile shows an insignificant
response under either model. (See Table 3 in the Appendix.) When
considered alone, this evidence appears to support Hypothesis 1:
that the market wants options expensed.
[25] To be
thorough, we also examined returns in the period around April 22,
1994 (Date 3), when a WSJ article announced that the FASB was
likely to delay, for at least one year, any rule requiring that
options be expensed. For the full sample of 2,540 firms on Date 3,
and for the first three quartiles, both models reveal no
significant responses. For the lowest quartile, Model 1 revealed no
significant response and Model 2 revealed a positive 0.39% response
at the 95 percent level.
[26] Even though
more weight would be given to an official announcement than to news
from a secondary source, it seems unlikely that investors concerned
about this issue would not have responded at all when the WSJ
announced there would be a likely delay. Indeed, when returns for
the announcement day (Day 0) are examined, out of 10 possible
responses (two models, each examining responses from the full
sample and the four quartiles), there were five insignificant
responses and five positive responses with no discernible pattern.
(See Table 3.) Thus, the results for the period around Date 5
appear to contradict the support for Hypothesis 1 found with regard
to Date 2. Since the results for these two dates seem to be
conflicting, it is better to view all of the results together
rather than separately.
The last date to be examined is July 6, 1995 (Date 6), when a
WSJ article announced that it was likely that, within one week, the
Financial Accounting Standards Board would announce the footnote
disclosure that is still in use in 2002 (in FAS No. 123). Under
both models, the full sample of 2,701 firms, the highest quartile,
and the upper-middle quartile show significantly positive
responses. (See Table 3.)
Furthermore, since
the FASB did not require that options be expensed on this date and
only stipulated that the figures be placed in a footnote, the
responses for Date 6 do not necessarily support the claim that
the market wants the options expensed (Hypothesis 1). In fact, the
result of the announcement was that employee stock options would
not be expensed. It could just as easily be argued, therefore, that
these positive responses indicate the market does not want options
expensed on the income statement.
The real cost of
employee stock options is the potential dilution to firms? existing
shareholders. Whether the Financial Accounting Standards Board
requires option expensing or not, it appears that the market is
able to account for their value (provided information on options
granted is disclosed). The six separate event studies in this
paper found virtually no evidence to support the notion that the
market is not capable of valuing employee stock options under the
existing accounting rules.[28] While we did not study the hypothesis
directly, it is also possible that some firms would actually prefer
to expense their employee stock options because of the tax
benefits.
Finally, employee
stock options can contribute to the earnings of millions of working
Americans, and Congress should not taint them by associating them
with the recent spate of corporate scandals? which is clearly a
separate issue.
Norbert J. Michel is
a Policy Analyst in the Center for Data Analysis at The
Heritage Foundation. Paul Garwood is a Ph.D. candidate at the
University of New Orleans.
Appendix
[1]Christopher Byron, MSNBC.com, July 17, 2002, at . If this link is no longer active, the article can
be obtained from the authors.
[2]In fact, a widely accepted model to
evaluate any type of options did not exist. In the early 1970s,
standard put-and-call options, which are different from employee
stock options, were not heavily traded.
[3]Fischer Black and Myron Scholes, "The
Pricing of Options and Corporate Liabilities," The Journal of
Political Economy, Vol. 81,
Issue 3 (1973), pp. 637-654.
[4]The upward trend in issuing these
options seems to have continued. According to Bear Sterns, the
number of options granted by the firms in the S&P 500 in 2001
was nearly 7.5 billion, an increase of nearly 50 percent from the
level granted in 1998. See Bear Sterns, "Accounting Issues" report,
Employee Stock Option Expense, Is the Time Right For Change?
July 2002.
[5]This bill was defeated in the Senate by
a vote of 88-9.
[6]T. J. Rodgers, "Options Aren't Optional
in Silicon Valley," The Wall Street Journal, March 4, 2002, p. A14.
[7]While several accounting rules have been
shown to be irrelevant to investors, very little work has been done
on the rules for employee stock options. For information on other
accounting rules that have been deemed irrelevant to the market,
provided there is full disclosure, see R. S. Kaplan and R. Roll,
"Investor Evaluation of Accounting Information: Some Empirical
Evidence," Journal of Business, Vol. 45, April 1972.
[8]According to Bear Sterns, the firms in
the S&P 500 reported just under $80 billion in pre-tax option
expenses in 2001, with the technology sector accounting for nearly
half of the total. See Bear Sterns, Employee Stock Option
Expense.
[9]The shares could also come from
"authorized but un-issued shares." When a company issues new
equity, it frequently holds some of the new shares in reserve
rather than placing all the shares on the market. Granting these
shares for the options has the same effect as granting shares from
treasury stock-additional shares are put on the market.
[10]See Zvi Bodie, Robert Kaplan, and Robert
Merton, "Options Should Be Reflected in the Bottom Line," The Wall
Street Journal, August
1, 2002, p. A12.
[11]The cost of equity capital is the return
that investors require on their equity investment. Unlike the cost
of debt capital (i.e., the interest paid on debt), there is no
explicit cost for equity capital.
[12]We can assume that there are no non-cash
expenses, so that the net income is equal to the net cash
flow.
[13]Incidentally, the next best alternative
forgone (i.e., the opportunity cost) for employee stock options
would not be selling the options on the market; it would be the
cost of paying the worker with cash. Absent perfect knowledge and
risk neutrality, this amount is sure to vary from the
estimated value of the options-yet another reason accounting
statements should not include these costs.
[14]Bear Sterns, Employee Stock Option
Expense.
[15]According to FAS No. 123, any method can
be used to value the options as long as it "takes into
account…the exercise price and expected life of the option,
the current price of the underlying stock and its expected
volatility, expected dividends on the stock and the risk-free
interest rate…." See FAS No. 123, paragraph 19.
[16]There are varying assumptions about time
to expiration. In practice, nearly all employee stock options are
exercisable over a range of years.
[17]Statistical significance refers to the
probability that a hypothesis is rejected when it is actually true
(this is referred to as a Type I error). Typically, the significance level is
set at 0.05 or 0.01, which means that the probability of a Type I
error occurring is 5 percent or 1 percent, respectively. It is
common, as in the results discussed below, to use the complement of
the significance level. For example, reporting that a hypothesis is
rejected, at the 95 percent level of significance, means that there
is a 95 percent probability that a Type I error was not
made.
[18]Eventus® uses a t-statistic to test for significant
abnormal returns. Basically, this sort of test checks to see
whether the difference between the mean returns for the sample
and the market index (during the event window) is statistically
significant. Using the terminology in note 18, a statistically
significant difference between the mean return of the sample and of
the market, at the 90 percent level, is synonymous with rejecting
the hypothesis that the returns are the same. The 90 percent
significance level indicates there is a 90 percent probability that
a Type I error has not occurred (that the mean returns are the
same). For more information on the t-statistic, see Edwin
Mansfield, Statistics for Business and Economics, 5th Edition (New
York: W. W. Norton, 1994), Chapter 9.
[19]Wall Street Journal articles were used because the Journal
is one of the most widely read financial newspapers in the United
States. While it is possible that an important announcement related
to these accounting rules could have been omitted from the Journal,
it is reasonable to assume that all major announcements were in
this publication.
[20]The citations for the articles from
which the event dates were taken are as follows: Lee Berton, "FASB
Is Likely to Postpone Requiring Stock Option Deduction From
Earnings," The Wall Street Journal, April 22, 1994, p. A2; Lee Berton,
"Business Chiefs Try to Derail Proposal on Stock Options," The Wall
Street Journal, February 5, 1993, p. A2; and Roger Lowenstein, "The
Cost of Employee Stock Options, Now Hidden, Might Earn a Footnote,"
The Wall Street Journal, July 6, 1995, p. C1. It should be noted
that all four of the tables included herein are based on data
developed by the tests explained in this paper.
[21]The listing for item #215 is as follows:
"This item represents shares reserved for stock options outstanding
as of year-end plus options that are available for future grants.
Prior to August 22, 1996, this item included: (1) Shares subject to
shareholder approval, and (2) Stock appreciation rights
attached to or associated with stock options. This item is not
available for banks, utilities or property and casualty companies."
Because item #215 is not collected for these sectors, they are
omitted from our samples.
[22]Each quartile consists of 25 percent of
the sample, based on the ratio measure, less any firms for which
CRSP could not find usable returns.
[23]The quartile sample sizes vary because
of unavailable stock returns in CRSP.
[24]While Table 4 includes the results from
30-day and 60-day windows, these results are not discussed in the
paper. According to standard methodology, using the wider
event windows increases the probability of measuring a response to
another event. For the sake of completeness, however, the tests
were run using these windows as well. Even when the larger event
windows are used, over 60 percent of the measured responses, for
both the CARR and the announcement dates, are statistically
insignificant.
[25]At the very least, these results suggest
that the market can tell how many options firms issue. Our tests
also indicate that there was a statistically significant difference
between the responses of the highest and lowest quartile on Date 2.
Similar differences were found between the highest and lowest
quartiles on all other announcement dates where statistically
significant responses were found. These tests are available
upon request.
[26]To check for an endogeneity problem, the
tests were re-run for Date 5 using an equally weighted portfolio,
and all responses, for the full sample and all of the quartiles,
were insignificant. The endogeneity problem, which does not appear
to exist here, occurs when large, well-known firms in the sample
realize a drop in their stock price. This drop, because the large
firms represent a large portion of the value-weighted portfolio,
causes a false positive response in the lowest quartile. This
alternate test was performed when the lowest quartile was the only
sub-sample to show a positive response. Our results were similar
using both the equally weighted and value-weighted
index.
[27]The test with the equally weighted
portfolio revealed similar results, with both models showing
insignificant responses for the lowest quartiles.
[28]Given that Compustat reported the number
of options issued over the time period studied, it seems
particularly difficult to argue that the market could not tell how
many options firms issued.