Robust stock option plans

The main purpose of this paper is to address the issue of robustness of stock option plans, which is essential for reliable accounting valuations. The introduction of the accounting standards SFAS 123R and IFRS 2 for executive stock options has led to an important change. As companies are now forced to value their stock options at grant date for accounting purposes, the robustness of prices against the choice of certain valuation models and input parameters has become a very important issue. We address this issue by first analyzing certain building blocks of existing stock option plans with regard to their robustness properties. Based on our analysis, we then show how robustness of stock option plans can be achieved. The resulting stock option plans are both transparent in structure and reasonable in respect to the incentives they provide in order to increase shareholder value. We therefore conclude that stock options can be reliably expensed, if the corresponding plans are properly designed.     

Finance, Politics, and the Accounting for Stock Options

The politics of option accounting crosses party lines, reflecting both the interests of the affected constituencies and the desire for power over standard setting. House Bill HR-3574, which mandates an assumption of zero stock price volatility, runs counter to the recently passed Financial Accounting Standards Board (FASB) rule requiring fair-value expensing of stock options. For any option issued at or out of the money, where strike prices are normally set, expense recognition is zero under this bill's mandated assumption.
Besides excessive use of stock options, the lack of a "final peace" in the option accounting war appears to have encouraged another questionable corporate practice. This article examines a sample of "six-and-one restructurings," exchanges of options in which expensing of re-priced (deep out-of-the-money) options can be avoided if employees wait at least six months and one day before receiving new options. The authors found that market-adjusted stock prices tend to decrease during the six-month period before the strike price is reset. This result provides one more reason why companies should be required to use fair-value option pricing models to expense options.     

Making imaginary worlds real: The case of expensing employee stock options

West [West, B. (2003). Professionalism and accounting rules. London: Routledge] and Chambers [Chambers, R. J. (1966). Accounting evaluation and economic behavior. Houston: Scholars Book Company] have provocatively argued that financial reporting has reached a state of near-total incoherence. In this paper, we argue that a source of this incoherence is the transformation of the US accounting academy into a sub-discipline of financial economics, a transformation in which accounting became a servant of the imaginary world of neoclassical economics. After noting the unusually prominent role of rules within the accounting profession, we describe the displacement of accounting’s centuries-old root metaphor of accountability by the metaphor of information usefulness, and situate that displacement within neoliberalism, a broader political movement that arose after World War II. Finally, we use SFAS 123R, the recently issued stock option standard, as a case study of the incoherence that West and Chambers assert. Through various issues – such as reflexivity, theory paradox, and unexplained questions of responsibility – we demonstrate the logical inconsistencies involved in SFAS 123F. The incoherence of stock option reporting rules raises serious questions about the information metaphor as a foundation for either individual rules or the standard setting process. The Financial Accounting Standards Board’s (FASB) attempts to make the imaginary world of neoclassical economics real have resulted in rules which are not defensible.     

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.     

Stock Option Measures and the Stock Repurchase Decision

The major purposes of this study are two fold. First, we investigate whether or not the dilutive effect from stock options on the denominator of earnings per share is associated with the incurrence of stock repurchases. We use the FASB dilution and the economic dilution as the direct dilution measures and examine their relationship with stock repurchase decision. Second, we explore which of the extant measures of stock options can better explain the incurrence of stock repurchases. Six extant measures of stock options from previous studies are used: (1) the FASB's treasury-stock EPS dilution method, (2) the economic dilution measure based on Core, Guay and Kothari (2002), (3) the number of employee stock option exercises, (4) the number of stock option grants, (5) the number of total stock options outstanding, and (6) the number of exercisable stock options.Using a pooled cross-sectional sample from 1996–2000, we find a positive association between the likelihood of stock repurchases and the FASB dilution as well as the economic dilution in EPS, respectively. Thereby providing support for the undo-dilution hypothesis. The highest incremental explanatory power is found when we add the number of stock options exercisable to the baseline model. However, further analysis does not support the option-funding hypothesis suggested by Kahle (2002). We provide two explanations for why exercisable stock options better explain the stock repurchase decision.     

Hicksian Income in the Conceptual Framework

In seeking to replace accounting conventions by concepts in the pursuit of principles‐based standards, the FASB/IASB joint project on the conceptual framework has grounded its approach on a well‐known definition of income by Hicks. We welcome the use of theories by accounting standard setters and practitioners, if theories are considered in their entirety. Cherry‐picking parts of a theory to serve the immediate aims of standard setters risks distortion. Misunderstanding and misinterpretation of the selected elements of a theory increase the distortion even more. We argue that the Boards have selectively picked from, misquoted, misunderstood and misapplied Hicksian concepts of income. We explore some alternative approaches to income suggested by Hicks and by other writers, and their relevance to current debates over the Boards' conceptual framework and standards. Our conclusions about how accounting concepts and conventions should be related differ from those of the Boards. Executive stock options (ESOs) provide an illustrative case study.     

Pedagogic metaphors and the nature of accounting signification

This paper concerns three metaphors for financial statements associated with accounting education: lenses, photographs, and the board game, Scrabble. These metaphors not only describe financial statements but also affect our interpretations of them and our behavior towards them. The lens metaphor has many implications that accounting cannot live up to; however, that does not mean that it is an inappropriate metaphor to express our aspirations for accounting and to inspire our students. The Scrabble metaphor is a somewhat pejorative metaphor that we may cynically apply to accounting, but it may also be an effective means of criticizing mindless manipulation of financial statement elements. The photographic metaphor, occupying a middle ground, might be the most intriguing of the three. At an elementary level, it captures some simple truths about accounting, or at least some simple statements we would like to be true. But as the complexities of the metaphor are explored, they reveal a variety of intriguing ontological issues that concern financial statements.     

Understanding accounting through conceptual metaphor: ACCOUNTING IS AN INSTRUMENT?

This paper extends the conversation about metaphors in accounting that were presented in this journal by McGoun et al. [McGoun EG, Bettner MS, Coyne MP. Pedagogic metaphors and the nature of accounting signification. Critical Perspectives on Accounting 2007a;18:213–30; McGoun EG, Bettner MS, Coyne MP. Money n’ motion—born to be wild. Critical Perspectives on Accounting;2007b;18:343–61.]. Our aim is to promote further critical conversations about how metaphor is implicated in accounting. We assemble and review some of the empirical evidence we have gathered from close readings of discourse about accounting over the past decade. Based on this empirical grounding, we propose that the fundamental conceptual metaphor, ACCOUNTING IS AN INSTRUMENT, has been deployed commonly to describe the essence of accounting. We contend that such deployment has insidious, distortive and confounding outcomes because it encourages belief that accounting is incapable of reporting other than with representational faithfulness; and that it confounds the (alleged) primary qualitative characteristics of accounting information (relevance and reliability) outlined in the Financial Accounting Standards Board's SFAC 2 Qualitative Characteristics of Accounting.     

Companies' Modest Claims About the Value of CEO Stock Option Awards

This paper analyzes company disclosures of CEO stock option values in compliance with the SEC's regulations for reporting executive compensation data to stockholders. Companies appear to exploit the flexibility of the regulations to reduce the apparent value of managerial compensation. Companies shorten the expected lives of stock options and unilaterally apply discounts to the Black-Scholes formula. Theoretical support for these adjustments is often thin, and companies universally ignore reasons that the Black-Scholes formula might underestimate the value of executive stock options. The findings not only cast light upon how corporations value executive stock options, but also provide a means of forecasting compliance with controversial new FASB requirements for firms to disclose the compensation expense represented by executive stock options.     

Which approach to accounting for employee stock options best reflects market pricing?

We use a residual income valuation framework to compare equity valuation implications of four approaches to employee stock options (ESOs) accounting: APB 25 “recognize nothing”, SFAS 123 (revised) “recognize ESO expense”, FASB Exposure Draft “recognize and expense ESO asset” and “recognize ESO asset and liability”. Theoretical analysis shows only grant date recognition of an asset and liability, and subsequent marking-to-market of the liability, results in accounting numbers that capture the dilution effects of ESOs on current shareholder value. Out-of-sample equity market value prediction tests and in-sample comparisons of model explanatory power also support the “recognize ESO asset and liability” method.     

A Critical Look at SFAS 34: Capitalization of Interest Cost

In 1974, the Securities and Exchange Commission (SEC) noted that an increasing number of companies were capitalizing interest costs, and that this practice was not being adequately disclosed (FASB, 1979, par. 26). In light of the alternative practices concerning the accounting for interest and lack of adequate disclosure by companies that were already capitalizing interest, the SEC recommended that the Financial Accounting Standards Board (FASB) consider the issue of accounting for interest cost. As a result of the SEC's initiative, in 1979 the FASB issued Statement of Financial Accounting Standards [SFAS] No. 34, Capitalization of Interest Cost, which mandated uniform interest capitalization rules in accounting for interest costs associated with the acquisition of qualifying non-current assets. The purpose of this article is to examine SFAS 34 in terms of its financial statement impact, the congruence of its assumptions with economic behaviour, its effect on subsequent standards related to interest capitalization, and its implications on financial accounting standard setting. To explore these issues we first illustrate the extent to which interest capitalization affects financial statements. We then empirically analyse the measure employed in SFAS 34 for the capitalization of interest cost in cases where debt is not directly linked with the acquisition of qualifying non-current assets. In addition, we critically examine the treatment accorded interest cost in subsequent FASB standards. Our research suggests that SFAS 34′s rationale for interest capitalization is incompatible with firm behaviour, and that the rules for interest capitalization as reflected in various accounting standards are inconsistent. These findings suggest that in the case of interest capitalization the benefits of comparability in financial reporting are not realized. A policy recommendation is then offered to alleviate some of these difficulties. The recommendation is to disallow the capitalization of interest cost in the absence of a direct link between the debt and the acquisition of qualifying assets.     

An IFRS 2 and FASB 123 (R) Compatible Model for the Valuation of Employee Stock Options

In this paper, we show how employee stock options can be valued under the new reporting standards IFRS 2 and FASB 123 (revised) for share-based payments. Both standards require companies to expense employee stock options at fair value. We propose a new valuation model, referred to as Enhanced American model, that complies with the new standards and produces fair values often lower than those generated by traditional models such as the Black–Scholes model or the adjusted Black–Scholes model. We also provide a sensitivity analysis of model input parameters and analyze the impact of the parameters on the fair value of the option. The valuation of employee stock options requires an accurate estimation of the exercise behavior. We show how the exercise behavior can be modeled in a binomial tree and demonstrate the relevance of the input parameters in the calibration of the model to an estimated expected life of the option. JEL Classification G13, G30     

Risk(ing) Metaphors

Metaphors appear in almost every realm of our existence permeating even the supposedly “literal" contexts of high-energy physics laboratories and play a central role in defining and organizing both everyday and scientific realities. Metaphors are not an optional literary device but rather enable us to understand and experience one thing in terms of another. They focus our attention upon particular aspects of a thing that we might otherwise overlook and, in doing so, they also deflect our attention from other aspects. In directing and deflecting our attention, metaphors help us to construct our perceptions of reality in particular ways, guide our actions, and are used to frame issues as problems and to assess the feasibility and appropriateness of various possibilities as solutions. Metaphors are also found within the pages of highly technical texts such as The Original Pronouncements produced by the Financial Accounting Standards Board (FASB). In this paper, I begin to examine more closely the metaphors that the FASB has included in its texts. Specifically, I highlight the many different metaphors that have been used in connection with risk by the FASB. These metaphors have included orientational, attribute, and ontological metaphors. I end by commenting that these metaphors have contributed to the thinkability of risk management and to considerations of risk as an opponent that must and should be confronted and managed. I question the blind spots in our thinking about risk that these metaphors may be creating and perpetuating and suggest how different metaphors might lead to different ways of thinking about risk.     

Valuing reload options

Over the past quarter century, the use of stock options as pay for performance has grown enormously. Option grants now account for 32% of CEO pay—more than twice that of salaries. In addition options are now being granted to many more employees than before. During this same time period, there have been numerous innovations in the features on compensation options. One of these features is the reload—the grant of new options to replace shares tendered in the payment of the exercise. Within the past year, the long-delayed FASB requirement that options be expensed for financial reporting has finally become a fact. It is incumbent upon financial researchers to provide methods to achieve the goal of valuing options, not only to serve the accounting needs, but also to provide ways of determining their true costs and incentive effects. This paper analyzes the various forms of reload options and provides simple Black-Scholes like formulas for evaluating them. JEL Classification G13     

A metaphorical analysis of The Love Song of J. Alfred Prufrock by T. S. Eliot

Using the theory of conceptualisation of metaphor, this study analyses the imagery created by accounting metaphors of The Love Song of J. Alfred Prufrock. The paper applies a typology of metaphors as the basis of metaphorical analysis for the detection of accounting in Eliot’s poem. The results of the study suggest that the poem relies on accounting metaphors that use either unstated vehicle concepts, unstated tenor concepts or both to convey dense messages of accounting. An implication arising from the results is that considerable transfers of meaning from one epistemic element to another are needed to unlock Eliot’s accounting messages.     

The association between financially expert independent directors and the accounting for employee stock options

This study investigates how the financial expertise of independent directors is associated with voluntary accounting policy decisions. As representatives of a company’s shareholders, financially-expert independent directors are more likely to cause management to pursue higher quality accounting policy decisions. The policy decision investigated involves the expense/non-expense policy choice for employee stock options as previously permitted under SFAS No. 123. Using a sample of 174 option-expensing firms and a matched control sample of 174 non-expensing firms, the results indicate a significant, positive association between the decision to expense employee stock options and the financial expertise of a company’s independent directors. Further, a significant, negative association was found between the option-expensing decision and whether the chief executive officer was the largest internal blockholder.     

A Comparison of Measures of Earnings Per Share

Abstract

This paper explores alternative methods for computing earnings per share (EPS) for a company whose capital structure consists of ordinary shares and warrants. The methods for computing EPS identified by the FASB (1996) are critically evaluated and an alternative measure, the holding period approach,is developed within the framework of contingent claims analysis. Two types of errors are shown to characterize the accounting measures of EPS. One arises from failure of accounting measures to fully recognize the contingent nature of the warrant. The other arises from the practice of not recognizing instances of anti-dilution. A further factor is the treatment of any difference between the proceeds from the issue of the warrants and their fair value at that time. This is ignored in existing measures and yet may have a significant effect on the value of the claims of ordinary shareholders on the company’s earnings. Using a simulation method it is shown that the imputed earnings method of computing EPS is a very close approximation to the holding period method and is considerably more accurate than treasury stock measures favoured by accounting standards bodies.     

An examination of the perceptions of auditors and chief financial officers regarding principles versus rules based accounting standards

The debate over the adoption of International Financial Reporting Standards (IFRS) by United States issuers, or its convergence with U.S. Generally Accepted Accounting Principles (U.S. GAAP) has been going on for several years now. However, as of this writing, the Securities and Exchange Commission (SEC) has still not taken a definitive position on the issue. This is in part due to issues involving the cost of adoption, independence concerns relating to the IFRS promulgation body, the International Accounting Standards Board (IASB), and the debate over which type of accounting standards is superior for financial reporting: IFRS, which are said to be “principles-based,” or U.S. GAAP, which are said to be “rules-based.” In this paper we examined the views of two stakeholders in the U.S. financial reporting system, auditors in large public accounting firms and Chief Financial Officers in the Fortune 1000. We elicited their perceptions involving ten situations where specific rules are incorporated in U.S. GAAP. We asked if the elimination of the specific rule would be likely to better achieve the “qualitative characteristics of useful financial information” as defined by the Conceptual Framework for Financial Reporting adopted by the Financial Accounting Standards Board (FASB) in 2010 (FASB 2010) and the similar document adopted by the IASB at the same time (IASB 2010). We found that in eight of the ten situations both groups preferred the rules-based accounting regime (the current U.S. GAAP rules) over a principles-based approach.     

Stock options and managerial incentives for risk taking: Evidence from FAS 123R

We provide new evidence on the relation between option-based compensation and risk-taking behavior by exploiting the change in the accounting treatment of stock options following the adoption of FAS 123R in 2005. The implementation of FAS 123R represents an exogenous change in the accounting benefits of stock options that has no effect on the economic costs and benefits of options for providing managerial incentives. Our results do not support the view that the convexity inherent in option-based compensation is used to reduce risk-related agency problems between managers and shareholders. We show that all firms dramatically reduce their usage of stock options (convexity) after the adoption of FAS 123R and that the decline in option use is strongly associated with a proxy for accounting costs. Little evidence exists that the decline in option usage following the accounting change results in less risky investment and financial policies.     

Constructing, persuading and silencing: the rhetoric of accounting standards

Members of the Financial Accounting Standards Board (FASB) and its staff are continuously engaged in a variety of efforts to persuade individuals that the work of this entity is valuable, appropriate, useful and correct. In this paper, I focus upon the persuasive efforts that are employed in “official” accounting standards. These documents do more than simply detail new technical accounting requirements. The texts have been shaped to express a particular point of view about the significance of events and activities that occurred during the standard-setting process and contain numerous efforts to persuade readers to accept this perspective. In particular, I argue that the FASB employs rhetorical strategies in its accounting standards that construct (and attempt to persuade us) that a specific standard is “good”, that silence alternatives and possible criticisms of the standard and that construct the FASB as a “good” standard-setter. These strategies help to construct standards as technical products and thereby also work to maintain the myth of accounting objectivity.