The Accounting Review Vol. 66 No. 3 1991
Valuation of Executive Stock Options and the FASB Proposal
Abstract
[Under existing generally accepted accounting principles, no compensation expense is recorded for executive stock options (ESOs) if the exercise price on the date of grant is equal to (or greater than) the market price of the stock. Similarly, only negligible compensation expense tends to be recorded if the exercise price on the date of grant is less than the market price of the stock. The inadequacy of this method (see Boudreaux and Zeff 1976; Smith and Zimmerman 1976; and Weygandt 1977) has led the Financial Accounting Standards Board (FASB) to consider a proposal to measure compensation related to grants of ESOs at their fair values, with a lower bound constraint. A candidate model for the estimation of fair value (Swieringa 1987) is the Black and Scholes (B-S) (1973) pricing model with the Merton (1973) modification that allows for continuous-dividends. It would seem natural (and we infer that the FASB would opt) to use the continuous-dividend version of the B-S model for firms that pay cash dividends and the no-dividend version for firms that do not pay dividends. Note that if cash dividends are assumed to be zero (as would be the case for firms that do not pay dividends), the continuous-dividend version reduces to the original B-S formulation. Thus, we label the B-S continuous-dividend model (subject to the stipulation that the B-S estimate not be less than the number yielded by the FASB's minimum-value model) as the FASB proposal. This labeling applies whether the grant date or the vesting date is considered to be the measurement date (discussed below). To examine the income effect of changing the accounting method of ESOs, this study applies the FASB's proposal to a random sample of firms that granted stock options in order to assess the impact of the related compensation expense on operating income. A second objective is to compare ESO compensation estimates from the two models underlying the FASB proposal: (1) the B-S continuous-dividend model, and (2) the FASB's minimum-value procedure (discussed subsequently). In addition, the latest FASB proposal requires that stock option compensation be measured as of the vesting date, as opposed to the date of grant. Thus, a third objective is to provide evidence as to whether vestingdate estimates of ESO compensation are significantly different from ESO estimates generated on the grant date. The results indicate that, using a three percent materiality threshold, more non-dividend paying firms (about 30 percent) would have material income effects than dividend-paying firms (about eight percent). Furthermore, using alternative measures of service periods shorter than the lives of options, produces material ESO compensation expense for a high percentage of sample firms. Finally, applying the FASB proposal on the basis of the vesting date would result in a lower income effect than applying it on the basis of the date of grant. In general, material income effects are observed when the FASB's proposal is adopted irrespective of the valuation model used.]
- Volume
- 66
- Issue
- 3
- Pages
- 595-610
- Sources
- bibtex:phds-export.bib