Do firms understate stock option-based compensation expense disclosed under SFAS 123?

Do firms understate stock option-based compensation expense disclosed under SFAS 123? Focusing on the four key option pricing model inputs—expected option life, expected stock price volatility, expected dividend yield, and the risk-free interest rate for the expected life of the option—this study finds that firms understate option value estimates and, thus, stock-based compensation expense disclosed under SFAS 123. As predicted based on incentives and opportunities for management to understate SFAS 123 expense, the understatement of option value estimates is increasing in proxies for the magnitude of the expense, is greater for firms with weaker corporate governance, and, to a lesser extent, is increasing in the excessiveness of executive pay. The findings are strongest for the expected option life and expected stock price volatility input assumptions, consistent with firms’ greater latitude in determining these inputs. We find weaker evidence of understatement associated with the expected dividend yield assumption, and none for the interest rate assumption, consistent with these inputs being less amenable to discretion. Taken together, our findings raise some concern that the exercise of management discretion adversely affects the overall reliability of SFAS 123 expense. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Accounting Studies Springer Journals

Do firms understate stock option-based compensation expense disclosed under SFAS 123?

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Publisher
Springer Journals
Copyright
Copyright © 2006 by Springer Science+Business Media, LLC
Subject
Business and Management; Accounting/Auditing; Corporate Finance; Public Finance
ISSN
1380-6653
eISSN
1573-7136
D.O.I.
10.1007/s11142-006-9013-0
Publisher site
See Article on Publisher Site

Abstract

Focusing on the four key option pricing model inputs—expected option life, expected stock price volatility, expected dividend yield, and the risk-free interest rate for the expected life of the option—this study finds that firms understate option value estimates and, thus, stock-based compensation expense disclosed under SFAS 123. As predicted based on incentives and opportunities for management to understate SFAS 123 expense, the understatement of option value estimates is increasing in proxies for the magnitude of the expense, is greater for firms with weaker corporate governance, and, to a lesser extent, is increasing in the excessiveness of executive pay. The findings are strongest for the expected option life and expected stock price volatility input assumptions, consistent with firms’ greater latitude in determining these inputs. We find weaker evidence of understatement associated with the expected dividend yield assumption, and none for the interest rate assumption, consistent with these inputs being less amenable to discretion. Taken together, our findings raise some concern that the exercise of management discretion adversely affects the overall reliability of SFAS 123 expense.

Journal

Review of Accounting StudiesSpringer Journals

Published: Sep 27, 2006

References

  • Market valuation of employee stock options
    Aboody, D.
  • Voluntary recognition of stock-based compensation expense
    Aboody, D.; Barth, M. E.; Kasznik, R.
  • CEO stock option awards and the timing of corporate voluntary disclosures
    Aboody, D.; Kasznik, R.

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