Disclosure versus recognition: the case of expensing stock options

The SFAS 123R comment process generated over 6,500 comment letters, most of which were against the standard’s enactment. This outpouring of emotion indicates that many believe that disclosure versus recognition matters. Our paper provides evidence for the debate whether managers’ discretion, motivation, and accuracy of stock option estimates differ under the recognition and disclosure reporting regimes. We compare firms that are mandatorily forced to recognize stock options expense with those voluntarily choosing to do so. First we find that mandatory firms (versus voluntary) with more intensive stock option granting tend to understate option estimates, especially in the post SFAS123R period. Our results suggest that a higher recognition cost motivates firms for doing so. Second, we find that mandatory firms with lower future operating risk have better accuracy in the post SFAS123R period, as compared to themselves in the pre SFAS123R period and voluntary firms in the post SFAS123 period. Our results support the notion that the informativeness of option estimates explains the level of accuracy. The findings of this paper add to the debate on the benefits of recognizing stock option expenses.     

Valuing employee stock options under SFAS 123R using the Black–Scholes–Merton and lattice model approaches

In 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payments (SFAS 123R), requiring all entities to recognize as expense the fair value of stock options issued to employees for services provided. Because employee stock options cannot be traded publicly, their fair value must be estimated using a model, with the Black–Scholes–Merton (BSM) and lattice models being the most appropriate alternatives.This teaching note provides an overview of employee stock options, followed by a discussion of the BSM and lattice valuation models, including their application and limitations. A project which has been used in financial accounting courses is also presented. The conceptual discussion coupled with illustrated examples will help students enhance their understanding of fair value estimation of and accounting for employee stock options under the recently adopted SFAS 123R.     

Accounting standard’s effectiveness on equity overstatement – Conservatism when it matters

This paper evaluates the effectiveness of FASB’s standards on accounting conservatism when a firm is likely overstating assets or understating liabilities. Specifically, this paper considers whether conservatism increases due to SFAS 87, 106, 121, 142, and 123R, conditional on the firm being an aggressive reporter. To test these standards, I perform two time-series analyses from 1976 though to 2010. The first analysis compares the number of observations with a book to market ratio (BTM) greater than one to all observations at the industry level. The second determines whether each standard is correlated with a reduction in the probability of a firm having a BTM greater than one. I use the BTM greater than one to identify firms that should be more conservative (avoid equity overstatement), and to exclude those that are biasing earnings to artificially low levels. The results are consistent with only some of the standards, SFAS 106 (Employers’ Accounting for Postretirement Benefits Other Than Pension) and SFAS 142 (Goodwill and Other Intangible Assets), being effective in reducing equity overstatement.     

Accounting conservatism and voluntary corporate governance mechanisms by Australian firms

This study examines the relationship between voluntary adoption of selected corporate governance mechanisms and accounting conservatism for a sample of firms listed on the Australian Securities Exchange (ASX) over the 11‐year period prior to the promulgation of the ASX Corporate Governance Council Good Governance Principles and Best Practice Recommendations in 2003. Using four accounting and market‐based accounting conservatism measures, our results provide evidence of both conditional and unconditional conservatism in accounting reporting for Australian firms. We find that voluntary audit committee formation, increasing board independence and decreasing board size are positively associated with unconditional accounting conservatism and negatively related to the degree of conditional conservatism. Our results support the contention that firms voluntarily adopting perceived best practice corporate governance mechanisms employ unconditional accounting conservatism as a complimentary agency control device and are consistent with the observed negative association between the unconditional and conditional forms of accounting conservatism practice.     

Accounting conservatism and the profitability of corporate insiders

We predict that accounting conservatism influences insiders' opportunities to speculate on good and bad news, and thus, insider trading profitability. We find that greater conditional (unconditional) conservatism is associated with lower (higher) insiders' profitability from sales. We find limited evidence that conservatism influences profitability from purchases. These findings are consistent with our hypotheses on the different informational roles of conditional and unconditional conservatism, and on the asymmetric influence of conservatism over the opportunities to speculate on good versus bad news. Our research design takes into consideration the endogenous nature of insiders' trading and conservatism. The results are robust to different measures of conservatism and a number of additional analyses.     

The Economic Determinants of Conditional Conservatism

Abstract:  We study the economic determinants of conditional conservatism. Consistent with prior literature, we find that contracting induces only conditional conservatism and litigation induces both conditional and unconditional conservatism. We extend prior evidence by Qiang (2007) by showing that taxation and regulation induce not only unconditional conservatism, but conditional conservatism as well. We show that in certain scenarios taxation and regulation create incentives to shift income from periods with high taxation pressure and high public scrutiny to periods with lower taxation pressure and lower public scrutiny. These income shifting strategies are implemented by recognising current economic losses that, given managerial incentives to report aggressively, would not have been recognized otherwise, or by delaying the recognition of current economic gains that would have been recognized had circumstances been different.     

Conditional conservatism and the limits to earnings management

We examine the impact of conditional conservatism on earnings management. Our findings support the view that conditional conservatism reduces accruals-based earnings management but also triggers a trade-off between accruals and real earnings management. In our main tests we use the passage of SFAS 121 as a plausibly exogenous regulatory change that increased the level of conditional conservatism but did not materially affect earnings management. We find that, after the regulation, treated firms reduce accruals-based earnings management and increase real earnings management, and are less likely to be marginal or habitual beaters of earnings benchmarks. Given the crucial role of earnings for firm valuation and analysis, and that conditionally conservative accounting choices are observable, our results should be of wide interest for investment professionals.     

Unexpected Accruals and Conditional Accounting Conservatism

Abstract:  This paper examines the impact of management discretion over accruals on conditional accounting conservatism, defined as the tendency of accountants to recognize bad news on a timelier basis than good news. Prior research suggests that conditional accounting conservatism reflected in earnings is mainly due to the accrual component of earnings, not the cash flow component of earnings. After decomposing total accruals into expected and unexpected accruals, I find that (1) conditional accounting conservatism reflected in accruals is mainly due to unexpected accruals; (2) the negative association between unconditional and conditional accounting conservatism is mainly attributable to unexpected accruals; and (3) firms with higher leverage exhibit conditionally more conservative accounting primarily through unexpected accruals. These results are robust to accrual models that take into account the systematic association between accruals and cash flows and their non-linearity and to the asymmetric persistence of earnings changes specification of conditional accounting conservatism. Taken together, these results suggest that managers exercise their discretion over accruals to expedite the recognition of bad news rather than good news.     

Firms' Voluntary Recognition of Stock-Based Compensation Expense

We investigate factors associated with firms' decisions in 2002 and early 2003 to recognize stock‐based compensation expense under Statement of Financial Accounting Standards (SFAS) No. 123. We find that the likelihood of SFAS 123 expense recognition is significantly related to the extent of the firm's participation in capital markets, the private incentives of top management and members of the board of directors, the level of information asymmetry, and political costs. Although recognizing firms have significantly smaller SFAS 123 expense, we find no significant incremental relation between recognition likelihood and SFAS 123 expense magnitude after controlling for other factors that we expect explain the recognition decision. We also find positive and significant announcement returns for earlier announcing firms, particularly those stating that increased earnings transparency motivates their decision.     

Do investors misprice components of net periodic pension cost?

We examine whether and how investors misprice the components of net periodic pension cost under SFAS No. 87 and 158. We find that investors appear to have difficulty in understanding the transitory feature of other net periodic pension cost (PPOPCC) and thus overestimate its persistence, which in turn leads to the mispricing of PPOPCC in the pre‐158 period. We also find that SFAS No. 158 appears to reduce the mispricing of PPOPCC, suggesting a positive effect of SFAS No. 158 on investors' valuation of pension items in the income statement. Additional analysis suggests that investors also overestimate the persistence of, and thus misprice, pension‐related cash flows and accruals in the pre‐158 period and that SFAS No. 158 reduces the mispricing of pension‐related cash flows and accruals.