Disclosure versus Recognition of Option Expense: An Empirical
Investigation of SFAS No. 148 and Stock Returns
Steven Balsam
Fox School of Business and Management
Temple University
Philadelphia, PA 19122
Eli Bartov
Leonard N. Stern School of Business
New York University
New York, NY 10012
Jennifer Yin
College of Business
University of Texas – San Antonio
San Antonio, TX 78249-0631
ABSTRACT
Is quarterly employee stock option expense reported under the recently promulgated
SFAS No. 148 value relevant? If so, is there a differential valuation effect related to the
placement of the option expense within the financial statements, i.e., on the income
statement or only in a footnote? Using a sample of 142 distinct firms (363 firm quarters)
that recently began recognizing option expense voluntarily, and thus reported both
disclosed and recognized option expenses, we find that whether the quarterly option
expense is only disclosed in the footnotes, or whether it is also recognized in the income
statement, the market values the cost associated with employee stock options as an
expense. More importantly, we also find that the market valuation of that expense does
not differ whether the amount is only disclosed in the footnotes, or whether it is also
recognized in the income statement. Our findings are especially topical given the newly
promulgated SFAS No. 123 (revised 2004), Share-based Payments.
In this
pronouncement, the FASB mandated income statement recognition for employee stock
option expense for all firms starting (with a few exceptions) on June 15, 2005. By
showing that market participants equally value the stock option expense whether it is
disclosed or recognized, we show that firms need not worry about the first order effect of
mandated recognition on their share prices.
Disclosure versus Recognition of Option Expense: An Empirical
Investigation of SFAS No. 148 and Stock Returns
While SFAS No. 123 encouraged firms to use the fair value method of accounting
for employee stock options on the income statement (see par. 62 of SFAS No. 123), until
the summer of 2002 only a few firms elected to recognize option expense.1 In response to
the accounting scandals of 2001 and 2002 (e.g., Enron, WorldCom, Global Crossing), a
number of large publicly traded companies began voluntarily recognizing option expense
using the fair value method. To improve the accounting for the transition from disclosure
to recognition, in December of 2002 the Financial Accounting Standards Board (FASB)
issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and
Disclosure. SFAS No. 148 increased the frequency with which firms disclose their proforma numbers, requiring quarterly disclosures starting with the first quarter of 2003, and
improved the prominence and clarity of the SFAS No. 123 pro-forma disclosures by
prescribing a specific tabular format reporting the total stock-based compensation cost
using the fair value method, as well as the amount recognized on the income statement.
Prior research has investigated the relation between SFAS No. 123 annual option
expense and equity values with conflicting results. Rees and Stott (2001), who examine a
sample of 756 firms making disclosures in 1996, the first year the disclosures were
required under SFAS No. 123, find a positive association between returns and disclosed
stock option expense. Similarly Bell et al. (2002) investigate a sample of 85 profitable
companies from the software industry (three-digit SIC code 737) for the three-year
1
For example, of the S&P 500 firms only two firms, Boeing and Winn-Dixie Stores Inc., recognized option
expense.
1
period, 1996-1998, and find a positive relation between annual option expense disclosed
in the footnotes and the market value of common equity at fiscal year end. Conversely,
Aboody et al. (2004a), who use the same three-year sample period but a larger sample of
2,274 firm-years, document a negative correlation between disclosed annual option
expense and both year-end stock prices and annual raw stock returns.
Related research has also investigated the valuation effect of recognition versus
disclosure, again with mixed findings. Clearly, in a rational market with little information
processing costs or contracting costs, whether the costs are expensed or recognized
should not affect valuation. However, the FASB in Concepts Statement No. 2 (SFAC
No. 2), “Qualitative Characteristics of Accounting Information,” observes that
recognizing information in financial statements requires a higher level of reliability
relative to disclosing information outside of financial statements. Extant empirical
evidence is generally consistent with this observation. Libby, Nelson, and Hunton (2005)
find that the auditors not only make decisions to include information within the financial
statements based on its reliability, but further also appear to contribute to the added
reliability of included material by requiring greater correction of misstatements of
amounts recognized in financial statements as compared with those disclosed in the
footnotes. Davis-Friday et al. (1999, 2004) find that investors value the disclosed liability
for retiree benefits other than pensions differently than the recognized liability, and
Aboody (1996) finds the market values price changes in the oil and gas industry
differently depending upon whether those price changes are disclosed or recognized.
The purpose of this paper is two fold. First, by utilizing the quarterly disclosures
provided under SFAS No. 148, we assess the value relevance of the newly promulgated
2
disclosure requirement that option expense be disclosed quarterly. Second and more
importantly, by utilizing a sample of firms that have voluntarily adopted the recognition
provisions of SFAS No. 123 recently, we examine whether the valuation effects of
disclosed and recognized option expense are equal.2 Due to its greater perceived
reliability, investors may place more weight on the recognized portion of the option
expense, which in turn will lead to a differential valuation effect of disclosed versus
recognized option expense. Conversely, if investors price stocks based on the nature of
the information regardless of its placement in the financial statements, no differential
valuation effect should be observed.
When compared to prior research examining the differential effects of recognition
versus disclosure our setting is unique. While we examine amounts recognized and
disclosed for the same firm in the same quarter, Davis-Friday et al. (1999 and 2004)
contrast the same firm in different years, i.e., the last year under a disclosure regime with
the first year under recognition, and Aboody (1996) does his comparison across different
firms, i.e., he compares firms using the full cost versus those using the successful efforts
method of accounting. This unique setting should increase the power of our tests as well
as the reliability of our findings.
Our sample consists of 142 distinct firms (363 firm-quarters) spanning the first
three quarters of 2003, the first year SFAS No. 148 was in effect. Following prior
research (Bell et al. 2002, and Aboody et al. 2004a), we isolate the effect of option
expense on stock returns by using a specification that considers seasonal changes in
2
Most of the firms adopting the recognition provision of SFAS No. 123 elected to do so prospectively.
Consequently, while they recognized the cost associated with the options granted after the date of adoption,
the cost associated with options granted prior to adoption was only recognized in pro-forma income. Thus
the firms have both recognized and disclosed amounts.
3
earnings, unexpected earnings growth, and firm size as control variables, in addition to
our two test variables, unexpected recognized and unrecognized option expense.3
Using quarterly size-adjusted buy-and-hold abnormal returns (CAR), we find, as
expected, that both unexpected disclosed and recognized quarterly option expenses are
value relevant. More importantly, we find that disclosed and recognized option expenses
are reflected in stock returns as expenses and in a similar fashion. That is, regressing
CAR on recognized option expense and unrecognized option expense—after controlling
for variables shown by prior research to explain stock returns—we find that the
coefficients on the two option expense variables are negative and the difference between
them is statistically insignificant. Furthermore, results from the Heckman (1979) test
indicate these findings are not due to a self selection bias.
Our findings contribute to extant literature on the value relevance of option
expense in two ways. First and foremost, we contribute to the ongoing debate on option
disclosure versus recognition by showing that the placement of the option expense,
whether in the income statement or only in the footnotes, makes little difference in terms
of investor perceived costs associated with employee stock option grants. Specifically,
corporate executives have been lobbying regulators for more than a decade against option
expense recognition because of the perceived adverse economic consequences of
recognition. Our results indicate that the economic consequences of option expense
recognition are unlikely to be significant.
Second, we are the first to document that SFAS No. 148 disclosures are valuation
Our proxy for the unexpected expense is this year’s expense less the expense in the same quarter of the
previous year, i.e., the seasonal difference. While to some extent this year’s unrecognized expense can be
anticipated as those options have been granted in periods prior to adoption, disclosure was and is not
refined enough to allow investors to fully anticipate this periods expense because neither the period over
which the expense was allocated, nor the timing of the grant within the year, need be disclosed.
3
4
relevant, and that unexpected option expense is negatively associated with changes in
firm value. This independent-of-prior-work evidence, generated by using quarterly rather
than annual data, comparing the effects of recognition versus disclosure using the same
firm in the same time period, and a more recent sample period (2003 versus 1996-1998),
is important in light of the conflicting results reported in prior research.
5
Reference
Aboody, D. 1996. Recognition versus disclosure in the oil and gas industry, Journal of
Accounting Research 34:21-32.
Aboody, D., M. E. Barth, and R. Kasznik. 2004a. SFAS No. 123 stock-based
compensation expense and equity market values, The Accounting Review 79(2): 251-275.
Aboody, D., M. E. Barth, and R. Kasznik. 2004b. Firms’ voluntary recognition of stockbased compensation expense, Journal of Accounting Research, forthcoming.
Bell, T., W. Landsman, B. Miller, and S. Yeh. 2002. The valuation implication of
employee stock option accounting for profitable software firms, The Accounting Review
77(4): 971-996.
Davis-Friday, P. Y., C. Liu, and H. F. Mittelstaedt. 2004. Recognition and disclosure
reliability: Evidence from SFAS No. 106, Contemporary Accounting Research 21(2): 399427.
Financial Accounting Standards Board. 2004. Statement of Financial Accounting
Standards No. 123 (revised 2004): Share-based Payments.
Heckman, J. 1979. Sample selection bias as a specification error. Econometrica 47 (1):
153-161.
Libby, R., Nelson, M. and J. Hunton. 2005. Recognition v. disclosure and auditor misstatement
correction: The cases of stock compensation and leases, Working Paper, Cornell University.
Rees, L., and D. M. Stott. 2001. The value-relevance of stock-based employee
compensation disclosures, The Journal of Applied Business Research 17(2): 105-116.
6