The Value Relevance of Alternative Methods of Accounting for Employee Stock Options

We use the residual income valuation framework to compare the equity valuation implications of four approaches to employee stock options (ESOs) accounting proposed by regulators: APB 25 quot;recognize nothingquot;, SFAS 123 preferred quot;recognize ESO expensequot;, FASB Exposure Draft quot;recognize and expense ESO assetquot; and quot;recognize ESO asset and ESO liabilityquot;. Our theoretical analysis shows that only a version that involves grant date recognition of an asset and a liability, and subsequent marking-to-market of the liability, results in accounting numbers that accurately reflect the dilution effects of ESOs on current shareholder value. The other accounting methods lead to overstatement of current equity value. Out-of-sample and in-sample empirical tests are used to assess value relevance of the four accounting methods. The out-of-sample tests compare contemporaneous equity market value predictions based on each of the four methods. The in-sample tests compare the model explanatory power from estimating equations relating to each of the four accounting methods. The out-of-sample tests indicate the method with grant date asset and liability recognition has the lowest prediction errors, followed by the Exposure Draft method, the SFAS 123 method, and the APB 25 method. Findings from the in-sample tests are largely consistent with our theoretical expectations and provide support for the grant date recognition of an ESO asset and liability