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

Wayne R. Landsman, Ken V. Peasnell, Peter F. Pope, Shu Yeh

Review of Accounting Studies · 2006 · Volume 11 · Issue 2

Abstract

We use a residual income valuation framework to compare equity valuation implications of four approaches to employee stock options (ESOs) accounting:APB25 “recognize nothing”,SFAS 123 (revised)“recognize ESO expense”, FASBExposure 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.

Keywords

Equity valuation, Employee stock options, ESO asset and liability, ESO expense, Residual income, Mark-to-market

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