Accounting for Employee Stock Options: What Can We Learn from the Market's Perceptions?

Abstract

The scope of this is paper is to provide new empirical evidence on the value relevance of employee stock options (ESOs) in Europe. We show, empirically, that the market participants when pricing a firm's equity place approximately the same valuation weights on the ESOdeferred compensation expense (the so called ''ESO asset'') and the compensation option liability (the so called ''ESO liability''). Our empirical findings support the theoretical work of Ohlson and Penman who suggest that the deferred compensation expense be treated as a contra-liability. The second contribution of our work rests on the nature of the ESO expense. We show that the distinction between persistent and non-persistent ESO expenses is of critical importance for the market participants. Accordingly, an improved accounting disclosure should assist the investors in assessing the long-term goals of the ESO plans at the firm level.

Equity Versus Liabilities Debate, in the Context of Accounting for Employee Share Options

“…Irrespective of the manner of settlement, the supplier of the goods or services is likely to receive the same value from the reporting entity, either in cash or in the entity's shares (IFRS 2 2004). Furthermore, in both cases the entity has an obligation to deliver something, the only difference being the item (cash or shares) (Bagna et al 2010;ED Share Based Payments 2002). The manner of settlement appears to be of little consequence in many circumstances because the recipient of shares (the employee) could immediately sell the shares on the market if the entity is listed, and in many cases, entities provide buyback facilities to their employees (FASB 2007).…”

“…In the academic literature, however, the predominant approach for evaluating the decision-usefulness of claim classification is the common equity valuation perspective (Clark 1993;Kirschenheiter et al 2004;Ohlson and Penman 2005;Landsman et al 2006;Bagna et al 2010). This is justified by the fact that financial markets focus on equity instruments, rather than debt instruments, and financial reporting, which seeks to serve financial markets, should prioritise shareholders' interests over creditors' (Ohlson and Penman 2005).…”

“…The International Accounting Standards Board (IASB) utilised the definition of a 'liability' 2 per the 2008 Conceptual Framework when developing International Financial Reporting Standard 2, Share-based Payment (IFRS 2). The resulting incongruous accounting treatment prescribed by IFRS 2 may reflect inadequate no-tions of 'equity' and 'liabilities' in the Conceptual Framework (Bagna et al 2010) and provides the basis for this paper.…”

“…1 In addition to the technical appropriateness of differentiating between the two type of share-based payment schemes (McGregor and Street 2007), accounting for either equity or liabilities per IFRS 2, based on the manner of settlement, runs the risk of preparers structuring transactions to avoid different accounting outcomes (Hirst et al 2005). Furthermore, research indicates that users of financial statements may interpret share-settled employee share options as liabilities (Landsman et al 2006;Bagna et al 2010). The International Accounting Standards Board (IASB) utilised the definition of a 'liability' 2 per the 2008 Conceptual Framework when developing International Financial Reporting Standard 2, Share-based Payment (IFRS 2).…”

“…Finally, a considerable body of share-based payments research is couched in an American economic or institutional context (Bagna et al 2010). We know very little about financial reporting, including the interpretation of equity and liabilities, beyond traditional Anglo-Saxon settings (see Brennan and Solomon 2008).…”