Academic journal article Academy of Accounting and Financial Studies Journal

Transparent Financial Reporting: Characteristics of Companies That Voluntarily Elect to Expense Stock Options

Academic journal article Academy of Accounting and Financial Studies Journal

Transparent Financial Reporting: Characteristics of Companies That Voluntarily Elect to Expense Stock Options

Article excerpt

ABSTRACT

Recent corporate scandals have focused attention on a number of accounting choice issues as well as the transparency of financial reporting. One heavily debated topic is the question of how to account for stock options. Under existing accounting standards, companies either record an expense on the income statement for stock options granted or simply disclose the information in the financial statement footnotes. Expensing the options is the more transparent choice. This study compares the characteristics of firms that recently switched to voluntarily expensing stock options with those of a control group of similar companies that continue to only disclose options. Results indicate that the larger the number of inside owners, and the larger the percentage of insider ownership, the less likely the company is to switch to expensing stock options. Additionally, companies with a greater number of institutional owners and larger, more independent Boards of Directors switch to expensing stock options more often. Finally, companies with more volatile earnings switch to expensing more often. Results for hypotheses related to companies with steadily growing earnings, a higher use of stock options for executive compensation, and relatively new Chief Executive Officers are not statistically significant.

INTRODUCTION

Recent corporate scandals have caused financial statement users and preparers to debate a variety of topics related to financial reporting, including the topic of financial statement transparency. One issue frequently raised with respect to transparency is the question of how to account for stock options issued to company executives.

In December 2004, the Financial Accounting Standards Board (FASB) amended the rules for accounting for stock options found in Statement of Financial Accounting Standards (SFAS) No. 123 (FASB, 1995 and 2004). Prior to amendment, SFAS No. 123 defined and encouraged (but did not require) the use of the fair value method. Under this method, an option-pricing model is used to determine the value of stock options, usually at the date the options are granted to employees. Such models factor in the current market price of the stock, its expected volatility, the option exercise price, the expected life of the option, the expected dividends on the stock, and the current risk-free interest rate for the expected life of the option. Compensation expense is recorded using the option values generated by the model.

Alternatively, SFAS No. 123 (prior to amendment) allowed companies to account for stock options using the intrinsic value method described in Accounting Principles Board Opinion No. 25 (APB, 1972). Under the intrinsic value method, compensation expense is measured as the difference between the market price of the stock (usually measured at the date the option is granted) and the option exercise price. Generally, the exercise price is set equal to (or less than) the current market price, the intrinsic value calculation results in a value of zero (or a negative value), and no expense is recorded. If a company uses the APB No. 25 approach, SFAS No. 123 (prior to amendment) requires footnote disclosure of net income, basic and diluted earnings per share as reported, compensation expense that would have been reported if the fair value method had been used, and pro forma net income, basic and diluted earnings per share that would have resulted if the fair value method had been used.

Historically, most companies have opted to use the intrinsic value method, thereby recording no expense for stock options issued and disclosing the fair values of the stock options in the footnotes. Prior to July 2002, the only two companies in the Fortune 500 to opt for the fair value method were Boeing and Winn-Dixie. However, in the wake of recent corporate scandals, there has been a trend towards switching to the fair value method--with over 100 companies announcing such a change since July 2002 (Robinson and Burton, 2004). …

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