The Value Relevance of Pro Forma Net Income under SFAS 123: Old Economy versus New Economy Firms

By Duangploy, Orapin; Durr, David | Academy of Accounting and Financial Studies Journal, May 2002 | Go to article overview

The Value Relevance of Pro Forma Net Income under SFAS 123: Old Economy versus New Economy Firms


Duangploy, Orapin, Durr, David, Academy of Accounting and Financial Studies Journal


ABSTRACT

This study examines the value relevance of pro forma net income prepared in accordance with SFAS 123 over the time period of 1997-2000 of 40 firms. Additionally, it compares the value relevance between companies classified as Old Economy versus those under the New Economy. It is motivated by the controversy surrounding the usefulness of pro forma net income disclosures using the fair value method to account for employee stock options. We find a significant negative correlation between pro forma net income and security returns. In addition, there is a significant difference in value relevance between Old Economy and New Economy stocks.

INTRODUCTION

This study investigates the value relevance of pro forma net income disclosed under SFAS 123. Value relevance is defined as a significant correlation between earnings and security return. Additionally, it will compare the value relevance between companies classified as Old Economy versus those under the New Economy. It is motivated by the controversy surrounding the usefulness of pro forma net income disclosures using the fair value method to account for employee stock options. Also, it is provoked by the potential impact of this controversy on the unprecedented popularity in the nineties of the dot-com companies which offered stock options as a common component of their compensation packages in the era of intense global competition. Under SFAS 123: Accounting for Stock-Based Compensation, companies have the option to account for employee stock options using the fair value method or to disclose in the notes to financial statements pro forma earnings and pro forma EPS as if the fair value method were used.

Stock options, which are rights given to employees entitling them to buy company stock at a certain discount price within a specified time period, enjoy the spotlight these days as the most effective means of creating participatory capitalism. They have become a common component of many companies' compensation packages, especially for start-up companies. However, their accounting has been controversial. Warren Buffet, one of the world's valued investors is one of the world's vocal critics of stock options. In his letter to his shareholders, he wrote: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

This controversy was first addressed by Accounting Research Bulletin (ARB) 43, later by Accounting Principles Board (APB) 25 and, in 1995, by SFAS 123. Stock options have been considered "stealth compensation" under APB 25. SFAS 123 was issued after compromising the massive oppositions in having to recognize stock options as compensation expense measured at the fair value of the options. It encourages rather than requires the use of the fair value of stock options as measurement of compensation expense. Companies are allowed to continue using the intrinsic value method in APB No. 25 under which compensation cost is measured as the excess of the market price over the option price. Most stock options plans are fixed and therefore have exercise price at least equal to current market prices at the grant date resulting in no recognition of expense. The fair value method, on the other hand, computes total compensation expense based on the fair value of the options expected to vest on the grant date. The computed compensation cost is recognized over the service period, which is usually the vesting period. However, companies adopting the intrinsic method are required to disclose in notes to financial statements the pro forma net income and pro forma EPS as if the fair value based method were used.

At the core of the controversy is whether the pro forma net income disclosed in the notes to income statement is useful to investors. This research provides empirical evidence on the extent to which the disclosed pro forma net income, which is derived as if the compensation expense were computed using the fair value method, is correlated with annual stock returns. …

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