Master's Thesis-The ESO Expensing Fued-Mfalila-Samson-1-2015-04-19-1

Running head: THE ESO EXPENSING FEUD 1
The ESO Expensing Feud
Samson M. Mfalila
Franklin University
ACCT 795
April 15, 2015
Thomas G. Seiler, D.B.A, J.D, CPA, CGMA

THE ESO EXPENSING FEUD 2
Abstract
In 2004, the Financial Accounting Standards Board (FASB) issued the Revised Financial
Accounting Standard 123 (now FASB ASC 718), which requires the recognition of the cost of
granting stock option plans as an expense on the income statement. However, the standard
received substantial criticism due to concerns, for example, that employee stock options (ESOs)
should not be expensed as ESO grants do not impose real costs to granting firms and that
adopting the standard will place heavy issuers of ESOs such as high-tech firms on a competitive
disadvantage as those firms for example will be forced to redirect funds available for research
and development projects to cover compensation expenses in order to attract and retain the best
talent. The purpose of this study is to examine whether the expensing of ESOs results to
incorrect earnings and whether doing so could have any negative economic consequences by
reviewing and evaluating related literature. The findings from this study indicate that the
expensing of ESOs does not result to incorrect earnings and does not result to any negative
economic consequences.

Table of Contents
Introduction………………………………………………………………………………………..5
Overview..................................................................................................................................... 5
Studies Addressing the Problem................................................................................................. 6
Deficiencies in Past Literature.................................................................................................... 8
Significance of the Study............................................................................................................ 9
Accounting Rules........................................................................................................................ 9
Purpose Statement and Research Questions ............................................................................. 10
Literature Review.......................................................................................................................... 11
The Real Cost of ESOs ............................................................................................................. 11
The Role of Quality Accounting Standards and Transparency on Effective Financial Markets
................................................................................................................................................... 13
ESO Pricing Models ................................................................................................................. 15
The Case for Expensing ESOs.................................................................................................. 29
Economic Consequences of Expensing ESOs .......................................................................... 31
Arguments against Expensing ESOs and SFAS No. 123 R Implementation ........................... 42
Analysis......................................................................................................................................... 47
The Real Costs of Issuing ESOs ............................................................................................... 47
Other ESO Pricing Models besides the Black-Scholes Model................................................. 47
The Economic Consequences of Expensing ESOs................................................................... 49
The Case against Expensing ESOs ........................................................................................... 51
Conclusion .................................................................................................................................... 51
The Real Costs of Issuing ESOs ............................................................................................... 51

Other ESO Pricing Models besides the Black-Scholes Model................................................. 52
The Economic Consequences of Expensing ESOs................................................................... 53
The Case against Expensing ESOs ........................................................................................... 54
Contribution to the Body of Knowledge................................................................................... 56
Theoretical or Practical Consequences of the Research ........................................................... 56
Limitations of the Research ...................................................................................................... 56

The ESO Expensing Feud
Overview
Employee stock options (ESOs) have proven to be the engine of growth in a capitalistic
economy in recent decades by fueling growth through spurring competition and innovation.
However, the extensive use of stock options as a means of incentive compensation has faced
much criticism in the wake of recent financial scandals such as Enron, Tyco, and WorldCom at
the turn of the century (Borrus, Hof, Lavelle, & Weber, 2003; Borrus, Dwyer, Foust, & Lavetie,
2002). Among a number of reasons, the pervasive use ESOs has resulted from their powerful
characteristic as monetary incentives (Tzioumis, 2008, p. 101). As monetary incentives, ESOs
provide motivational benefits (Daks, 2010; Hall & Murphy, 2003; Huddart, 1994). Studies have
shown that in general people need incentives—which can be either monetary or non-monetary
incentives—in order to exert the extra effort required to perform certain tasks well (Bailey,
Brown, and Coco, 1998; Bhatia et al., 2011; Bonner & Sprinkle, 2002; Braun, Kirsch, &
Yamamoto, 2011; Bailey-Dempsey & Reid, 1995). The general hypothesis regarding the effects
of monetary incentives on effort and performance is that incentives lead to greater effort than
would have otherwise been in their absence (Bonner & Sprinkle, 2002, p. 304). A number of
theories support this hypothesis: For example, the expectancy theory predicts that people act to
maximize expected satisfaction with outcome, while the agency theory postulates that
individuals will shirk on a task unless the task somehow contributes to their own well being
(Bonner & Sprinkle, 2004, pp. 307-308). Thus, ESOs can be a powerful driving force for
company performance as a result of their ability to motivate those granted to exert extra effort in
pursuing organizational objectives (Kato, Lemmon, & Schallheim, 2005, pp. 438-439).

By definition, ESOs are stock options granted to management or other employees, giving
the right to purchase company stock at a specific price over some period in time (Bulow &
Shoven, 2005, p.116). ESOs vary greatly in terms across firms; however, the main objective for
firm’s to grant them is providing a long-term motivational incentive for employees to act in the
best interest of the organization (Merchant & Van der Stede, 2012, pp. 368-374). ESOs motivate
employees to act in the best interest of the organization by encouraging employees to take
actions such as improving performance or encouraging teamwork, that will likely lead to the
appreciation of the company’s stock price. When the company’s stock price appreciates above
the ESOs exercise price—the contractual agreed upon price that the grantee can purchase the
company’s stock—the employee can realize a profit by acquiring the shares under the option
contract and selling them to the market. The important motivational aspect of ESOs is that the
grantee has a potential of realizing a significant profit in case the value of the company stock
rises significantly above the ESOs exercise price. As a result, ESOs are a powerful motivational
tool that costs the granting company less when compare red to other forms of incentive pay.
Studies Addressing the Problem
The proposal and eventually the issuance of the Revised Statement of Financial
Accounting Standards No. 123 (SFAS 123 R)—now FASB ASC 718-20—provoked an intense
debate regarding impacts of the standard. While some researchers and studies agree that the
benefits of FASB’s position outweigh the lost opportunities or benefits for not implementing the
standard, some researchers and studies strongly opposed the FASB’s view. For instance, studies
by Guay, Kothar, and Sloan (2003) and Dechow, Hutton, and Sloan (1996) favor FASB’s
position by demonstrating research results in favor of FASB’s position. Specifically, the study by
Guay, et al. (2003) outlines and explains why expensing the cost to firms for granting ESO is

necessary, while Dechow, et al. (1996) provides evidence that counter argues the position that
mandating firms to deduct their costs of granting ESOs from their earnings will have negative
economic consequences.
On the other hand, some opponents to the standard focus on the inherent limitations of
the valuation process proposed or required by the standard. For example, some studies propose
alternative ESO valuation methods by providing reasons and conclusions from research findings
confirming the flaws inherent within the implementation of FAS 123 (R) (Cron & Hayes, 2004
and Templin, 2005). In addition, Huang, King, and Sellers (2008) discuss ESO valuation issues
that could make the implementation of FAS 123 (R) difficult or less effective in enhancing the
reliability and usefulness of financial accounting information.
Nevertheless, other studies focus on the overall implication of adopting FAS 123 (R)
(Cowan, 2005; Gritsch & Snyder, 2004; LaGattuta, Ma, & Remeza, 2004; Yermack, 1998). For
instance, LaGattuta, el al. (2004) proposes that the inherent limitations of processes involved
within the valuation of ESOs could lead to a new source of auditor litigation. While, LaGattuta et
al. does not necessarily disagree with benefits that could result from implementing FAS 123 (R),
the study does offer some implications of the standard for auditors to consider during the
auditing process. In addition, Gritsch and Snyder (2004) suggest that the standard could reduce
or avoid accounting fraud by company executives through inflating earnings by not expensing
ESOs. On the other hand, studies by Yermack (1998) and Cowan (2005) focus on the negative
implications of the standard. Specifically, Yermack (1998) shows how and why mangers could
exploit the flexibility of the standard to their benefits, while Cowan (2005) stipulates that high
users of ESOs such as banking firms could alter their compensation packages to reduce the
effects of implementing the standard on earnings.

Deficiencies in Past Literature
While a handful of studies have articulated the advantages and disadvantages of the
implementation of SFAS 123 R (Guay, et al., 2003; Dechow, et al., 1996, Cron & Hayes, 2004;
Huang, et al., 2008; Templin, 2005), only Dechow et al. (1996) explored the implications SFAS
123 R might have to the economy, despite negative implications to the economy being cited as
one of the major causes for the widespread rejection of the standard. Since SFAS 123 R
opponents have cited multiple aspects of the standard that could have possible economic
consequences, the effects of the standard appear not to be fully explored yet. For instance,
Dechow, et al. (1996) found no evidence for investor reaction resulting from the mandatory
expensing of stock options based on the assumption that the market will react negatively on days
surrounding the release of the exposure draft by expecting negative economic consequences for
high growth firms that make extensive use of ESOs. Another possible reason for such
observation could be that no real negative economic consequences were known by the market
and as such the market showed no significant reaction during the release of the exposure draft.
As such, real economic consequences of SFAS 123 R are yet to be fully explored.
In addition, Templin (2005) argues that the concerns of standard setters for not accepting
the intrinsic value method for measuring ESOs could be addressed by requiring companies to
only grant in-the money ESOs (p.403). However, such requirement will contradict with the
underlying reason ESOs are granted by motivating the grantees to take actions that increase the
chance of increasing the value of the granted ESO. Thus, the real economic consequences of
employing the intrinsic value method versus implementing valuation procedures required under
SFAS 123 R are yet to be fully explored.

Significance of the Study
Understanding how the deduction of the estimated expense associated with a firm’s
decision to grant ESOs could affect the underlying economy is important for a number of
reasons. First, financial accounting information plays an important role in the economy by
meeting the information needs of investors and creditors. Since the primary method of conveying
financial information to parties external to a firm is through financial statements, financial
standards play an important role of ensuring that those external parties to the organization that
are in need of financial information obtain information that is timely, useful, and reliable. Thus,
understanding the economic implications of implementing SFAS 123 R will enable the
determination of whether the overall objectives of reporting timely, relevant, and reliable
information about the economic prospects of an enterprise are met by the standard. Second,
understanding the economic implications of implementing SFAS 123 R will provide practical
implications to the constituents of accounting information that could possibly suggest an
overhaul, improvement, or provide viable reasons for maintaining the standard as is.
Nevertheless, a flawed accounting standard could mean a flawed accounting system and
therefore could lead to flawed economic decisions. Understanding the economic consequences of
implementing SFAS 123 R will ensure that the standard is based on sound reasoning
Accounting Rules
According to Scott (2012), traditionally, ESOs have been accounted for in the United
States using the 1972 opinion 25 of the Accounting Principles Board (p.297). Scott noted that
APB 25 required firms issuing fixed ESOs to record a compensation expense equal to the
difference between the company’s stock market price at the date of the grant and the exercise
price of the option—the intrinsic value method (p.297). However, Scott noted that corporations

began to issue ESOs with exercise prices below or equal to their firm’s market price at the date
of the grant (p.297). According to Scott, that practice resulted to corporation recoding no
expense associated with the granting of ESOs, which were said to have real economic benefits to
the firm as the firm received real services from the granted employee (p.297).
In response, the Financial Accounting Standards Board (FASB)—the successor of the
Accounting Principles Board, proposed and eventually introduced Financial Accounting
Standard 123 to demand the inclusion of expenses relating to granting stock options on corporate
earnings. The standard overhauled APB 25 by requiring the estimation of the fair value of the
ESO at grant date and recognizing that expense ratably during the years the granted employee
performs service to the organization (Bulow & Shoven, 2005, pp.116-117). However, FASB’s
position faced significant criticism by igniting a heated debate on the benefits of implementing
the standard. In general, critics of the standard argued that options with no intrinsic value should
have zero fair value and should not give rise to expense recognition, measuring the compensation
expense at grant date is impossible, and that the proposed standard will have unacceptable
economic consequences (Nelson, et al., 2011, p.1072).
Purpose Statement and Research Questions
The general purpose of this study is to determine whether the expensing of ESOs results
to incorrect earnings and whether doing so could have any negative economic consequences.
More specifically, this study evaluates the merit of FASB’s decision to include the cost of
granting ESOs on an organization’s income statement. To accomplish that purpose, this study
will explore answers to the following research questions:
1. Does the issuance of ESOs impose real costs to shareholders?
2. Are there other models for pricing ESOs besides the modified Black-Scholes model?

3. What are the economic consequences of expensing or not expensing ESOs?
4. Are the arguments against FASB’s proposal based on sound logic?
Literature Review
The Real Cost of ESOs
Bens, Nagar, and Wong (2002) examined whether the awarding of employee stock
options (ESOs) imposes real costs to granting firms as investors become increasingly concerned
with the costs of such options (p.360). The study was motivated by the observation that
managers are extremely concerned about the dilution of earnings per share (EPS) resulting from
granting equity related compensation (p. 360). In particular, Bens et al. noted the prevalent
practice for managers to repurchase shares in order to mitigate dilution effects of ESO exercises
(p.360). The authors noted that although the net cash outflow required to repurchase shares for
EPS dilution management due to ESO exercises should have no effect real investment
opportunities as all investment opportunities with positive net present value (NPV) could be
financed externally in perfect capital markets, the presence of information asymmetry causes
external financing to be costly (p.363). Thus, Bens et al. concluded that managers prefer internal
rather than external financing due to the presence of imperfect capital markets (p.363). Thus, the
use of internally generated funds to repurchase shares for managing EPS dilution effects due to
ESO exercises limits funds available for financing other positive NPV projects (p.363).
Therefore, the general research question for the study was seeking an explanation of how such
share repurchase programs using internally generated funds divert firm resources away from
investing activities, at the expense of future earnings (p. 364). To understand how such share
repurchase programs are used to manage EPS dilution effects from ESO exercises, Bens et al.
(2002) developed hypotheses that annual share repurchases were positively correlated to ESO

exercises after controlling for option grants, firm performance, and other specific characteristics;
that research and development activity and capital expenditures (CAPX) were negatively
correlated to ESO exercises; and the future return on assets was negatively correlated to current
ESO exercises (pp.366-367).
To examine the hypotheses, Bens et al. (2002) used a sample of leading industrial
companies from the Standard and Poor’s (S&P) 500 index, excluding utilities, financial, and
transportation firms and ran regressions to test the hypotheses (pp. 368-389). The authors
conducted the tests in three stages: by first documenting the positive association between ESO
exercises and the value of treasury stock repurchases by a firm, then documenting the negative
association the value of ESO exercises and R&D and CAPX, and finally testing the existence of
negative future performance implications arising from short-term investment cuts from using
internally generated funds on share repurchase programs (p. 360).
Bens et al. (2002) found that investment reduction associated with ESO exercises appear
to be temporary, suggesting the reduction is not due to declining investment opportunities
(p.360). Those findings suggested that firms are likely to have lost positive NPV due to the
temporary investment cuts (p. 360). However, the authors found weak evidence supporting
future performance declines following such investment cuts, depending on the performance
metric used (p. 360). In general, Bens’ et al. findings collectively indicated that ESO exercises
potentially impose opportunity costs to firms in terms of foregone investment opportunities
(p.390).
Another study by Marquardt (2002) explored the existence of ex-post costs to firms
issuing employee stock option (ESO) grants and weather the Black-Scholes model provides
reasonable estimates of such costs (p. 1192). The study was motivated by the difficulty in

assessing the empirical validity of ESO valuation models due to the absence of market prices of
ESOs and the debate that the differences between listed options and ESOs could cause the Black-
Scholes model to overestimate or underestimate the real values of ESO. Due to the lack of
market prices for ESOs, Marquardt (2002) relied on techniques from economic forecasting
literature by viewing model values as forecasts of option values and studied a sample of 966
ESO grants over 1963 to 1984 (p. 1191). The results of the study indicated that the Black-
Scholes model appears to provide reasonable estimates of ex-post ESO costs for the average
ESO grant when adjusted for concavity in the time to exercise using the Hemmer et al (1994)
procedure and the effect of outliers are taken into account (p. 1214).
The Role of Quality Accounting Standards and Transparency on Effective Financial
Markets
Bhattacharya, Daouk, and Welker (2003) analyzed financial statements from 34 countries
for the period 1984 to 1998 to construct a panel data-set measuring three dimensions of reported
accounting earnings for each country and hypothesized that those three dimensions of reported
accounting earnings for each country were associated with uninformative or opaque earnings.
Bhattacharya et al.’s study was motivated by the decline in equity values experienced by the
United States that was attributed to investor concerns over corporate governance and accounting,
as investors perceived a decreased transparency in U.S. accounting numbers, a perception that
lead to investors demanding higher rates of return for compensating the added information risk
(p.642). The purpose of Bhattacharya et al.’s study was to investigate whether information risk
associated with accounting earnings impacts equity markets around the world (p.642).
Within the study, Bhattacharya et al. (2003) defined the earning opacity of a country as
the extent to which the distribution of reported earnings of firms in that country fails to provide

information of the true but unobservable economic earnings of firms in that country (p.642).
Moreover, the authors noted that reported earnings in a country could be opaque because of a
complex interaction among, at least, three factors, which are managerial motivation, accounting
standards, and the enforcement of accounting standards (p.642). For example, the authors noted
that earnings could be opaque because managers are motivated to manipulate earnings and they
could do that because accounting standards applied allow substantial flexibility and the
enforcement of those standards is weak (p.642). However, the authors noted the difficulty
associated with capturing all factors that could influence earnings opacity or the difficulty in
modeling how those factors interact to produce more or less opaque earnings (p.642). Therefore,
Bhattacharya et al. studied the outcome of the interactions of factors that lead to earning opacity,
by analyzing the outcome of such interactions, which was the distributional properties of
reported accounting numbers across countries and across time that suggested earnings opacity,
instead of investigating the inputs that lead to earnings opacity (p.642). Specifically,
Bhattacharya et al. evaluated accounting data for measures that are intended to capture three
attributes of earnings numbers that could lead to earnings opacity, which were earnings
aggressiveness, loss avoidance, and earnings smoothing (p.643). Then the authors constructed a
panel data-set for each of the identified three measures of earning opacity and combined the
panel data-sets to obtain overall earnings opacity times-series measure per country (p.643).
Bhattacharya et al. (2003) found that the estimates of average earnings opacity per
country were significantly associated with variables that could impact the overall quality of a
financial reporting regime of a country—the Center of International Analysis and Research
(CIFAR) disclosure index and the number of auditors per a 100,000 population (p.643).
Therefore, Bhattacharya et al. concluded that the increase in the measure of overall earnings

opacity in a country was linked to an increase in cost of equity and a decrease in trading within a
stock market of that country (p.643). Nevertheless, the authors noted that their cross-sectional
analysis documented associations between the proportion of auditors within a population and a
disclosure level and earnings opacity, suggesting that an increased enforcement of accounting
standards through auditing and increased disclosure may improve transparency (p.972). Most
importantly, the authors noted that their findings were consistent with the held belief that sharp
declines in U.S. equity prices during the early 2000s were in response to widely publicized
accounting scandals in the U.S. that heightened investor concerns over earnings opacity,
prompting the demand for higher risk premiums (p.673).
ESO Pricing Models
Despite a number of similarities that ESOs have with traded options, the features that
differentiate ESOs from TSOs have valuation implications to ESOs. A number of studies have
addressed the important features of ESOs that warrant ESOs to be valued through different
valuation processes or models other than traditional valuation models that are used to value
TSOs. For example, Huddart (1994) examined the valuation of ESOs and determined that some
aspects of ESOs make important implications to their valuation. For example, Huddart noted
that; because ESOs are non-transferable, the employee’s optimal exercise policy will not be
necessary in alignment with what ESO valuation literature might suggest (p.207). Furthermore,
since employees might prefer to exercise their ESOs prior to maturity, under the consideration of
certain factors such as risk aversion, investment opportunities, and wealth of the employee, such
behavior has implications on the eventual cost the employer might record as a result of granting
the ESO as that ultimate cost is dependent on the granted employee’s exercise policy (p.207).
Therefore, Huddart suggested that the early exercise of an ESO by the employee infers that the

ESO cost to the employer is much less than the estimated values provided by the Black-Scholes
model (p.207). Therefore, Huddart’s study presented an analytical framework for distinguishing
the features that make ESO valuation different from the valuation of traded stock options (TSOs)
(p.207). Specifically, Huddart highlighted the effect of risk aversion on the decision by the
employee to exercise their ESO and illustrated how such risk aversion reduces costs incurred by
the employer (p.208). In addition, Huddart demonstrated how such knowledge of employee early
exercise policy should impact the valuation of ESOs (p.208).
In the study, Huddart (1994) noted conditions under which an employee might exercise
their ESO at maturity and underscored that the employee might exercise their ESO early if any of
those conditions are relaxed (p.209). With an example, Huddart demonstrated that exercising an
ESO early is in fact an optimal exercise policy for an ESO grantee and referenced the prevalence
of employee behavior to exercise ESOs early in real life settings (p.216). Thus, Huddart showed
that the exercise of ESOs before maturity is both optimal and prevalent (p.216). Specifically,
Huddart demonstrated that knowledge of the employee’s ESO exercise policy is necessary for
the estimation of the cost of the ESO to the employer for the preparation of financial statements
(p.226). Such knowledge is important because the cost of the ESO to the employer decreases as
the set of circumstances that might induce early exercise of the ESO by the employee increase
(p.226). Thus, the cost of ESOs to employers should under normal circumstances be less than the
cost estimated by traditional option pricing models such as the Black-Scholes (p226).
In another study, Cuny and Jorion (1995) explained that executive stock options (ESOs)
differ from traded options due to vesting and portability restrictions (p.193). The authors noted
that executive departure from a firm forces early exercise, which in turn reduces the value of the
ESO (p.193). However, Cuny and Jorion added that the ESO valuation methodology through

multiplying the Black-Scholes option price by the departure probability ignores the possibility
that executive departure is less likely when the stock price is high; therefore executive departure
is positively correlated with the stock price (p.193). The authors therefore, showed that the
correlation between executive departure and the stock price implies substantial increase in option
values (p.193).
In the study, Cuny and Jorion (1995) noted that FASB’s position is that the non-
recognition of ESO-related compensation costs implies either that ESOs are free to employers or
that options have no value—neither of which is true (p.194). Therefore, Cuny and Jorion
concluded that recognizing an expense associated with all stock-based awards seems justifiable
as ESOs have value to both employers and employees (p.194). The authors noted that one
method for valuing ESOs is based on the Black-Scholes (BS) option pricing model of 1973. In
addition, the authors noted that the success of the application of the BS model in other fields
motivates the model’s application to the valuation of ESOs (p.194). However, Cuny and Jorion
argued that ESOs differ from standard options due to vesting and portability restrictions (p.194).
As a result, modified option valuation models such as the modification of the BS model to
determine the option’s price and them multiplying that price with the number of employees that
are expected to stay with the firm are employed (p.194). However, Cuny and Jorion noted that
such approach ignores that a key feature of ESOs is that the employee’s decision to leave a firm
and the employer’s decision to terminate the employee are both correlated with the firm’s stock
price (p.194). The authors explained that executives have an incentive to stay when the firm’s
stock price is high and that poor executive performance is likely to reflect on the firm’s stock
price and therefore lead to firing (p.194). Cuny and Jorion, therefore, demonstrated that the
positive correlation between the number of options exercised and the firm’s stock price yield

ESO values that are substantially higher than previously recognized (p.194). Therefore, the
authors underscored that a complete analysis of ESO values should consider both high ESO
values due to the positive correlation between a firm’s stock price and executive departure and
other features of ESOs that make their valuation different from traded options as identified by
Huddart (1994).
In another study, Carpenter (1998) introduced a simpler and more useful model for
valuing executive stock options (ESOs) that extended the ordinary American option model to
include random, exogenous exercise, and forfeiture characteristics. Carpenter’s study was
motivated by the theory that hedging restrictions faced by managers make the valuation of
executive stock options more difficult than the valuation of ordinary traded options. Carpenter
noted that the difficulty in valuing ESOs thwarted FASB’s efforts to develop a standard that
required firms to deduct the cost of ESOs from earnings (p.128). Carpenter explained that while
the opponents of FASB’s proposal argued that the difficulty and need for accounting for the non-
transferability of ESOs makes ESOs difficult to value, Carpenter’s study suggested that valuing
ESOs is possible in practice (p.128). The article focused on the cost of executive stock options to
shareholders, which Carpenter noted is the cost an outside unrestricted investor will pay for the
option (p.128). In addition, Carpenter noted that the understanding of exercise decisions of
executives is important for estimating the value of ESOs (p.128). However, while Carpenter
agreed that the effect of hedging restrictions on exercise policies of risk-averse executives may
be complex in theory, modeling the practical implications of those effects is empirically possible
(p.128). Therefore, Carpenter compared two models representing option holders’ exercise
policies (p.128). Carpenter’s first model was a simple ordinary American option model that
introduced an exogenous “stopping state,” in which an executive automatically exercises or

forfeits the option (p.128). Carpenter explained that the “stopping state” served as a proxy for
any aspect that causes the executive to terminate the option early, such as the desire for liquidity,
voluntary or involuntary employment termination, or any other similar event or aspect that is
relevant to executives but not to unrestricted option holders (p.129). Essentially, the Carpenter
noted, the first model was an extension of the binomial model of Jennergren and Naslund (1993)
(p.129). On the other hand, Carpenter’s second model assumed the executive exercises the option
according to a policy that maximizes expected utility, subject to hedging restrictions as
demonstrated by Huddart (1994) and Kulatilaka and Marcus (1994) (p.129). Carpenter explained
that the utility maximizing model not only includes a stopping state, but also includes other
unobservable factors such as the executive’s risk aversion, outside wealth, and potential gain
from a voluntary separation (p.129). Carpenter started by calibrating the two models through
choosing factor values that made modeled exercise payoffs, times, and cancellation rates best
match sample averages because the factors underlying the two models were unobservable
(p.129). Then Carpenter examined the performance of the two calibrated models in predicting
actual exercise patterns for a sample of 40 firms with data from the period 1979 to 1994 (p.129).
In the study, Carpenter hypothesized that the utility-maximizing model should perform better
than the extended simple American option model as the former has more flexibility and allows
for richer forms of interactions between early exercises or forfeitures at given levels of the stock
price (p.129). However, Carpenter noted that the two models performed almost identically
(p.129). Additionally, Carpenter noted no case that the utility-maximizing model outperformed
the extended American option model, even when the utility-maximizing model was examined
under a variety of other parameterizations (p.129). With such findings, Carpenter (1998)
concluded that the “stopping rate” could essentially be a sufficient statistic for the utility

parameters (p.129). In broader terms, Carpenter noted that the exercise patterns can be
approximately replicated simply by applying a suitable stopping rate without the need to make
assumptions about executive risk aversion, diversification, and the value of new employment
(p.129). Carpenter’s findings implied that a simple extension of the usual binomial model can be
adequate for valuing executive stock options (p.129).
Alternatively, Hull and White (2004) developed a practical approach for valuing
employee stock options (ESOs) that was theoretically sound and easy to implement in light of
SFAS 123 requirements (p.114). Their model was motivated by Rubinstein’s (1995) critique of
FASB’s proposal for implementing SFAS 123 (p.114). Specifically, Hull and White noted some
features of ESOs such long vesting periods, restricted trading, and forfeiture rules made standard
methods for valuing options inapplicable to ESOs (p.118). More specifically, Hull and White
noted that the valuation of ESOs must incorporate five factors of ESOs that make them different
from traded options which were:
1. The possibility of early exercise of ESOs
2. The long vesting periods
3. The possibility of employees leaving the company during the vesting period
4. ESO transfer restrictions
5. Dilution issues arising from the issuance of ESOs. (p.114)
Hull and White (2004) noted that the proposed methodology on SFAS 123 does did deal
with the distinguishing identified five features of ESOs well (p.115). Therefore, the authors
presented an enhanced SFAS 123 model that dealt better with the five features specific to ESOs
(p.116). Specifically Hull and White proposed extending the lattice model to value ESOs. Their
model differed from the basic SFAS 123 model by explicitly considering the possibility that

employees could leave the company after the vesting period and explicitly incorporating the
employees early exercise policy by assuming that early exercise happens when the stock price
reaches a certain multiple, M, of the exercise price (p.116). The authors noted that while the
employee exit rate could be directly estimated from historical data on employee turnover rates of
a category of option holders within the company, estimating the early exercise multiple, M, was
likely to be difficult (p.116). However, the authors noted that M could be estimated by
calculating the average ratio of the stock price to the strike price that employees have made
voluntary decisions to exercise their options in the past and such decisions were not made
immediately after the vesting period (p.116). Thus, Hull and White’s model employed a
binomial model under the assumptions that:
1. ESOs can be exercised only after vesting periods
2. A vested option is exercised prior to maturity if the stock price is at least M times the
exercise price
3. A probability exists that an option will be forfeited in each short period of time during
the vesting period
4. The same forfeiture probability exists that the option will terminate in each short
period of time after the end of the vesting period. During this period an option is
forfeited when it is out of the money or exercised immediately if in the money.
(p.116)
In general, Hull and White (2004) developed a model that overcame the weaknesses of
the basic SFAS 123 three-step model in valuing ESOs by modeling the option holder’s early
exercise strategy through estimating the amount by which the stock price must exceed the strike
price to trigger early exercise (p.118).

Additionally, Bulow and Shoven (2005) introduced another option valuation method for
determining the expense of ESOs to companies as an alternative to the proposed method for
expensing stock options implemented by the Financial Accounting Standards Board (FASB) on
November, 2005. Bulow and Shoven noted that FASB’s rule would have slashed reported
earnings of Standard and Poor’s (S&P) 500 by 8.6 and 7.6 percent and therefore making the
effect of the bubble twice as large, if the standard was applied to 2003 and 2004 earning
respectively (p.115). Thus, Bulow and Shoven argued that FASB’s proposal for expensing
employee stock options (ESOs) was deeply flawed as the methodology was complex, more prone
to earnings manipulation, and not consistent with how the rest of compensation related expenses
are treated on financial statements (p.115). The authors defend their claim by first identifying the
features that make ESO valuation different from the valuation of traded stock options (p.16).
First, the authors note that traded options usually mature in one year, while ESOs usually have
longer maturity periods ranging up to ten years (p.116). Second, the authors noted that ESOs
differ with traded options in that ESOs do not vest at grant date (p.116). In addition, the authors
noted that vesting patterns of ESOs differ across firms or within the same firm as for example
some ESOs may vest gradually over time, while others vest all at once (p.116). Moreover, the
authors explained that ESOs must be exercised when the employee leaves the company, even
after vesting (p.116). Nevertheless, the authors noted that ESO granted employees are normally
restricted from trading their ESOs around earnings release periods (p.116). In their study, Bulow
and Shoven (2005) began by first highlighting the problems associated with FASB’s
methodology for expensing ESOs by providing examples on how the methodology would work
in various circumstances associated with ESO grants (p.118). Then the authors explained how
FASB’s proposal was not consistent with how other forms of compensation expenses such as

salaries and wages are treated on financial statements (p.121). Last, the authors provided an
alternative methodology for determining and treating the expense associated with ESO grants on
financial statements (p.122).
Bulow and Shoven (2005) noted the benefits of their proposal as being consistent with
the current treatment of salary related expenses on financial statements, addresses objections
raised by FASB’s critics, and better achieves financial accounting objectives of decision
relevance, robustness, transparency, simplicity, comparability, and reliability (p.122).
Specifically, Bulow and Shoven proposed that most ESOs should be accounted for as 90 day
options that are extended by 90 days at the beginning of each quarter of employment (p.122).
The authors explained that their proposal was consistent with the reality that employees most
typically exercise or forfeit all vested options within 90 days after terminating employment
(p.122). The authors added that the major difference and advantage between their proposal in
comparison with FASB’s was that ESO expenses after the grant quarter depend on the current
price of the company’s stock, rather than the grant date value (p.122).
On the other hand, Anderson and Brisley (2008) modeled employee early exercise
behavior by introducing the µ model—a model that assumed that employees exercise voluntarily
whenever the extent that the ESO is in the money reaches a fixed proportion µ of the remaining
Black-Scholes value (p.89). Their model was motivated by limitations of the model developed
by Hull and White (2004) (p.88). Anderson and Brisley noted that the need to value employee
stock options (ESOs) for accounting or economic purposes made modeling of the early exercise
behavior of ESO grantees relevant as companies were increasingly recognizing that early
exercises by employees reduces the costs of ESOs to companies (p.80). In addition, Anderson
and Brisley postulated that while more companies were moving towards the use of lattice models

such as that proposed by Hull and White, empirical evidence suggested that the use of such
models is still imprecise, as for example two companies valuing ESOs granted to employees with
identical exercise behavior will come up with different values simply because one of the
companies enjoyed a more rapid stock price growth than the other (p.89). According to Anderson
and Brisley, the model by Hull and White assumed that employees voluntarily exercised their
ESOs whenever the option reached a fixed multiple M of the stock price, which introduced a
horizontal barrier where voluntary exercise will occur whenever the underlying stock price
reached that barrier (p.88). Alternative to the voluntary exercise boundary mode, Anderson and
Brisley’s model resulted to a “downward-sloping” model that required the stock price to be at
relatively high multiples of the strike price to induce early exercise during the life of the ESO,
while allowing voluntary exercise of the ESO at relatively low multiples of the strike price later
in the ESOs life (p.89). Similar to Hull and White’s M model, Anderson and Brisley’s µ model
took into account the ESOs characteristics such as vesting restrictions, forfeiture, and forced
early exercise (p.89). However, unlike the M model, the µ model took into account the early
exercise tradeoff between intrinsic value captured and the opportunity cost of the option value
foregone throughout the ESOs life (p.89). Thus, the empirical estimation of the µ parameter from
the observations of early exercises was less prone to bias caused by atypical stock price histories
(p. 89). In addition, Anderson and Brisley (2008) noted another lattice model variant of the M
model, which assumed that employees exercise voluntarily if a fixed maximum anticipated life,
L was reached (p.89). Anderson and Brisley noted that both the use of the L and M models was
conceptually incorrect because prices produced by both models were concave in nature as model
prices based on an average parameter of a population were greater than the average model prices
found when each parameter was used (p.89). Therefore, Anderson and Brisley compared the

ESO value estimates produced by both the L, M, and µ models and found that the µ model most
accurately approximated objective ESO value (p.89).
In another study, Carpenter, Stanton, and Wallace (2010) conducted a comprehensive
study of the optimal exercise policy of an executive stock option and the policy’s implications to
option costs, average life of the ESO, and alternative valuation concepts. The study was
motivated by the observed norm that wealthier or less risk–averse executives tended to exercise
their options later and therefore created greater option costs to companies (p.315). Carpenter et
al. compared their model approximated ESO values with values produced by the modified Black-
Scholes model and found that the approximation error depended on specific firm characteristics
(p.315). Therefore, Carpenter el al. showed the importance of accurately characterizing the
exercise policy for option valuation (p.316). The authors hoped that the results of their study
provided guidance on how to interpret models for estimating exercise rates and option costs
(p.316).
Additionally, King, Sellers, and Yingpin (2012) discussed how the risk-neutral
assumption underlying option pricing models can be used to construct single-period models to
explain the option valuation process by presenting a binomial example to explain the basics
principles underlying option pricing models. The study was motivated by the widespread use of
employee stock options (ESOs) as means of compensating despite much debate surrounding the
valuation of ESOs (p.7). The authors noted that while many valuation analysts use the Black-
Scholes option pricing model (BSOPM) to value ESOs, the use of the BSOPM in many cases
does not accommodate some specific features of ESOs and therefore lead to incorrect ESO
values (p.7). Therefore, the authors proposed the use of a lattice based model as a most dynamic
model for valuing ESOs and other forms of non-traded options (p.7). The authors used a

discussion approach and provided examples to furnish readers with a foundation in option
valuation models, their assumption, critical features, and limitations, in order to help in the
evaluation of the appropriateness of any given option valuation model within particular
circumstances (p.8).
Nevertheless, King, Sellers, and Yingpin (2014) discussed attributes of employee stock
options (ESOs) that complicate the valuation process by discussing the differences between
traded stock options (TSOs) and ESO contracts through focusing on the most value relevant
features found in ESO contracts but not in TSOs (p.8). Their study was motivated by the need
for overcoming challenges associated with the valuation of ESOs by providing valuation
professionals with the ability to evaluate the appropriateness of alternative valuation models and
critical assumptions associated with inputs of such models (p.8). The authors emphasized that an
ESO valuator should keep in mind that option valuation models were specifically designed to
value TSOs and if such valuation models are used to value ESOs without some modifications,
many of the models’ assumptions would be violated (p.8). Therefore, King et al. (2014) grouped
the value critical differences between TSOs and ESOs into two main categories:
1. Differences arising from differences in parties involved in the transaction
2. Differences arising from differences in characteristics of the securities involved. (p.8)
According to King et al. (2014), a critical and major difference between parties involved
in a TSO and ESO contract is that TSOs can be written and purchased by any individual, while
ESOs are written by the granting company to be specifically granted to employers of the granting
company (p.8). Therefore, when a TSO is written, sold, and eventually exercised, all of the
associated cash flows transfer between parties completely independent from the company
associated with the underlying stock; as such exchanges take place within the secondary market

(p.8). However, the authors noted that cash flow exchanges associated with the exercise of ESOs
take place between the granting company and the owner of the ESO (p.8). Thus, according to
King et al., the granting company provides shares to the owner of the ESO while simultaneously
receiving the proceeds of the strike price from the employee (p.8). King et al. explained that
since the exercise of an ESO requires the granting firm to provide additional shares to the
employee, the stock value of the firm is diluted, which in turn impacts the value of the ESO
being traded as well as the value of other pre-existing ESOs (p.8). According to King et al., the
values of the traded and other pre-existing ESOs are impacted when the share price of the firm’s
stock is impacted because the intrinsic value of an ESO is calculated as the difference between
the firm’s stock price and the strike price of the of the ESO (p.8). Thus, according to King et al.,
when the share price falls, the intrinsic value of the associated ESO falls, an aspect that models
designed to value TSOs does not incorporate (p.8). Therefore, the authors concluded that valuing
ESOs with traditional models designed to value TSOs without accounting for the identified
effect results to overvalued ESOs (p.8). Moreover, the authors added that when an ESO is
exercised, the granting firm receives proceeds from the exercise as well as a tax deduction equal
to the intrinsic value of the ESO (p.9). Such has an opposite effect on the share value of the firm
as the dilution effect, but at a lesser extent, the authors noted (p.9).
On the other hand, King et al. (2014) noted that the value of TSOs depends on the
interaction of six variables, in which all are inputs of the Black-Scholes model:
1. The firm’s stock price
2. The option’s strike price
3. The estimated future stock’s volatility during the remaining life of the option
4. The risk free rate of return over the remaining life of the option

5. The time till maturity of the option, and
6. Cash dividends. (p.9)
However, King et al. (2014) noted that the valuation of ESOs is much more complicated
as additional value critical elements are involved in the valuation (p.9). The authors noted the
additional value critical features of ESOs that are inapplicable to TSOs as:
1. The vesting and risk of forfeiture of the ESO
2. Marketability limitations of the ESO
3. Early exercises, and
4. Performance and market conditions. (p.9)
King et al. (2014) explained that vesting refers to the minimum period of employee
service required before the ESO can be exercised (p.9). Since the ESO is forfeited at any time the
employee leaves the firm prior to vesting, the risk of such forfeiture makes the underlying ESO
less valuable (p.9). Since TSOs do not have similar attributes, their valuation models do not
incorporate such characteristic (p.9). Therefore, ESO valuation professionals should estimate the
probability of such ESO forfeitures as the exclusion of such vesting conditions will overstate the
value of the underlying ESO (p.9). Moreover, King et al. noted that since ESOs are non-
transferable; their value is dependent on the interactions between vesting requirements, employee
turnover and forfeiture rates, and the luck of marketability of the ESO (p.9). Nonetheless,
performance and market conditions are additional ESO features that are foreign to TSOs (p.10).
The authors explained for example, an ESO could include a contractual requirement stating that
the ESO cannot be exercised unless the company’s return on investment reaches some
designated level (p.10). Thus, the presence of such contractual requirements complicates the
valuation of ESOs relative to TSOs (p.10).

The Case for Expensing ESOs
Foster, Koogler, and Vickrey (1991) examined the income effect of changing the
accounting of executive stock options (ESOs) by applying FASB’s proposal to a random sample
of firms that granted ESOs, in order to assess the impact of the related compensation expense on
operating income (pp. 595-596). In addition, the study evaluated FASB’s proposal requiring
ESO compensation expense measured at the vesting date rather than the grant date through
attempting to provide evidence indicating whether vesting date estimates of ESO compensation
are significantly different from ESO estimates generated on the grant date (p.596). In the study,
Foster et al. obtained a sample of 560 annual reports taken from approximately 3,500 annual
reports for the year 1985 from the University of Arizona’s library (p.598). During the study, the
authors assumed that the date of grant was the appropriate date on which to measure the total
ESO compensation expense.
Foster et al. (1991) found that greater income effects are obtained when using the vesting
date versus the grant date as the date to estimate ESO compensation costs for dividend paying
firms (p. 607). However, the authors concluded that grant date accounting is appropriate in
several grounds:
1. Grant date accounting is less costly
2. Grant date accounting is consistent with option-pricing theory
3. Grant date accounting entails no loss in information content. (p.609)
In another study, Bell, Landsman, Miller, and Shu (2002) investigated the market’s
perception of the economic effects of employee stock options (ESOs) on firm value. The study
by Bell et al. was motivated by findings of Stewart (1977), suggesting that ESOs give rise to a
valuable tangible asset as ESOs motivate employees to boost productivity, profits, and the firm’s

stock price (p.972). In addition, Bell et al. noted that the motivation effect of ESOs extends
beyond the vesting period over which SGAS No. 123 requires firms to expense ESOs, a
phenomenon that raised a possibility that an intangible asset exists even beyond the vesting
period (p.972). Therefore, Bell et al. explored the extent in which three methods for accounting
for ESOs—the method proposed on FASB’s Exposure Draft: Accounting for Stock Based
Compensation, SFAS No. 123, and APB No. 125—reflected the market’s assessment of the
effects of ESOs on firm value (p.973). In particular, the authors explored whether investors
viewed the expense related to ESO grants differently from other components of income as ESO
aligned interests of employees and shareholders (p.973).
In the study, Bell et al. (2002) analyzed a sample of 85 profitable software firms as
software firms were reported as having the highest ratio of options granted to shares outstanding
when compared to other industries (p.973). The authors restricted their sample to software firms
with positive net income to ensure their valuation model was well specified (p.973). Using a
valuation model following SFAS No. 123, the authors found that the market appeared to value
the cost associated with ESO grants not as an expense, but as an asset (p. 973). Specifically, Bell
et al. noted that the market appeared to value the cost associated with ESO grants as a proxy for
an intangible asset associated with the issuance of ESOs (p.973). On the other hand, the authors
found that the ESO asset was highly value relevant when a valuation model following the
exposure draft in which the ESO value is measured as an amortized fair value of the ESO was
used (p.973). However, when the authors repeated the same analysis by including the
unamortized ESO in the valuation model, the ESO expense was no longer value relevant, results
that suggested that the intangible asset has useful life longer than the option’s vesting period
(p.973).

In general, the findings by Bell et al. (2002) suggested that the market values ESO related
expenses differently from other components of income and other forms of compensation
expenses (p.973). Thus, the findings by Bell et al. suggested that the approach proposed in the
exposure draft on accounting for stock based compensation better reflects the market perception
on the effect of ESOs on profitable software firms (p.973). However, the authors warned that
their conclusions should not be used as a basis for policy recommendation as it was possible that
ESOs created a valuable intangible asset for profitable software firms but not for unprofitable or
firms in other industries (p.973).
Economic Consequences of Expensing ESOs
Rappaport (1977) pointed the growing need for standard setting of financial accounting
standards that govern what businesses must report and how businesses must describe their
economic operations to be viewed more broadly than simply from a technical accounting
perspective as legislation of accounting standards involves a potential redistribution of wealth in
a society by imposing restrictions or costs on some and conferring benefits to others (p.89).
According to Rappaport, financial accounting standards can affect behavior in the economy and
therefore wealth distribution in a society in three different ways: First, financial accounting
standards can affect behavior in the economy and therefore the redistribution of wealth by
affecting the behavior of intended recipients of corporate financial reports, such as shareholders,
creditors, and other investors (p.89). Second, financial accounting standards can affect behavior
in the economy and therefore the distribution of wealth in a society by affecting the behavior of
those, such as competitors, labor markets, suppliers, customers, government agencies, and
special interest groups whom corporate financial reports are not directly intended to but can gain
access to the reports because the reports are free and publically available (p.89). And third,

financial accounting can affect wealth distribution in an economy by affecting the behavior of
the reporting company that in anticipation of potentially adverse reaction from receivers of
reported information arising from its reporting according to required measurement and disclosure
standards chooses to alter its economic behavior (pp.89-90). According to Rappaport, accounting
numbers affect intended recipients of accounting information by governing both what is
disclosed and the basis of measurement on reported accounting information that influence
security prices and therefore the wealth of market participants. On the other side, Rappaport
explained that financial accounting information affects the behavior of unintended recipients of
accounting information by providing an opportunity for such recipients to use the publically
available financial reports to benefit their decision making processes (p.90). Rappaport
illustrated the behavior of such free riders by illustrating how labor unions could use publically
available financial reports to negotiate better labor contracts for their members; regulatory bodies
using financial reports as a basis for antitrust, environmental, or interest rates regulation; or
competitors, suppliers, and customers adjusting their strategies on the basis of financial reporting
numbers (p.90). Nevertheless, financial accounting numbers form the basis for aggregate
economic statistics that in turn form an important basis for macroeconomic policymaking (p.90).
Equally important, Rappaport noted that the reporting company in anticipation of behavior
changes of intended recipients and free-riders might alter its own reporting behavior, for example
by adopting policy changes in resource allocation to minimize the adverse impact of anticipated
behavior changes of intended recipients and free-riders (p.90).
In another study, Zeff (1978) examined the impact of accounting reports on decision-
making in the U.S. during the 1970s. In the study, Zeff proposed an economic consequences
argument to guide the standard setting process as individuals and groups that had rarely shown

interest in the standard setting process began to actively and forcefully intervene the accounting
standard setting process by making arguments that were not included in tradition accounting
discussions (p.56). Zeff noted a problem faced by the FASB in the standard setting process was
to identify a delicate balance between accounting and non-accounting during the standard setting
process (p.56). Therefore, Zeff identified the need of the FASB to consider the economic and
social implications of its proposed actions. In the study, Zeff defined economic consequences as
the impact of financial accounting reports on the decision making behavior of intended and non-
intended users of financial accounting reports (p.56). Zeff reinforced that the resulting behaviors
of such users of accounting information could be detrimental to interests of other affected parties
and therefore accounting standard setters should consider such consequences of their proposed
actions (p. 56).
To conduct the study, Zeff (1978) identified the following research questions:
1. How can standard setters deal effectively with third party intervention during the
standard setting process?
2. What are the implications of the economic movement to the FASB? (p.63)
In determining how standard setters should deal with third-party intervention effectively
during standard setting, Zeff employed a qualitative analysis. Zeff noted that standard setters
ought to enhance their liaison with third parties in the standard setting process. For example, Zeff
noted how the Committee of Accounting Principles (CAP) enhanced its liaison with third-party
interveners by providing a wide circulation of exposure drafts to bring interested parties more
closely to the standard setting process (p.60). In addition, Zeff noted the inability of the APB to
cope with pressures brought by third party organizations as an important factor leading to its
demise; however the FASB is more effective by including a number of third-parties such as the

Financial Executives Institute—a professional association of senior level financial executives—
in its group of sponsors (p.60). Therefore, Zeff showed that that the standard setting process was
in an era in which economic and social consequences of financial reporting standards could no
longer be ignored (p.63).
In a study by Graham, Harvey, and Rajgopal (2005), the authors interviewed over 400
corporate executives to determine the factors that impact reported earnings and disclosure
decisions (p.4). Graham et al. performed the study using a combination of interviews and survey
instruments to address issues relating to the implications of mandated financial recognition and
disclosure requirements that are impossible to address using traditional empirical studies, issues
such as the ability to discover new patterns of behavior and discovering new explanations for
unknown behavior (p.4). Graham et al. attempted to:
1. Understand whether managers cared about earnings trends or benchmarks, and if
so, to determine which behaviors are perceived as important
2. Identify what factors motivate firms to exercise discretion and sacrifice long-term
economic value to manage reported earnings
3. Determine how well various academic theories explain earnings management and
voluntary disclosure. (p.4)
Graham et al. (2005) surveyed and interviewed a broad group of CFOs from a sample of
a large cross-section of firms and analyzed the survey responses conditional on firm
characteristics. Specifically, the authors examined the relationship between executive response
and firm size, P/E ratio, leverage, credit rating, insider stock ownership, industry, CEO age, and
education of the CEO (p.7). The authors found that CFOs view reported earnings as more

important than cash flows (p.65). Specifically, the study showed that managers focus on meeting
or beating earnings benchmarks to:
1. Build credibility with capital markets
2. Improve the external reputation of the management team
3. Maintain or increase the firm’s stock price, and
4. Convey growth prospects of the firm. (p.66)
Thus, according to the authors, failure to meet earnings creates uncertainty about a firm’s
prospects and raises concerns on the possibility of hidden deeper problems within the firm
(p.66). Therefore, Graham et al. provided further evidence of the real economic consequences of
financial reporting information.
In another study Biddle and Hilary (2006) examined how accounting quality relates to
firm-level capital investment efficiency. The motivation of their study was the small amount of
literature analyzing the effects of accounting quality on investment versus the significant body of
literature that exists that examined the relation between accounting quality and financial market
characteristics (p.963). Biddle and Hilary noted that while findings from prior research indicated
that accounting opacity is associated with a higher cost of publically traded equity capital, the
authors argued that institutional features may be related to firm-level capital investment
differently than to equity market operations (p.963). Therefore, Biddle and Hilary attempted to
explore how accounting quality affects the efficiency of firm-level capital investments (p.964).
In their study, Biddle and Hilary (2006) developed two hypotheses to help understand how
accounting quality affects the efficiency of firm level capital investment, which were that higher
quality accounting enhances investment efficiency by reducing information asymmetry between
managers and outside suppliers of capital and that the effect between high quality accounting and

investment efficiency was stronger in economies where financing was largely provided through
arm’s length transactions (p.964).
To test the first hypothesis, Biddle and Hilary (2006) estimated investment-cash flow
sensitivity for firms from 34 countries, and then analyzed how investment-cash flow sensitivity
across countries varied with accounting quality (p.964). Biddle and Hilary measured accounting
quality using three proxies for earnings quality (p.964). The authors found that accounting
quality is associated with lower investment-cash flow sensitivity (p964). In addition, the authors
found that other institutional features such as creditor rights and disclosure quality play a similar
role (p.964).
To test their second hypothesis, Biddle and Hilary (2006) regressed cash flow sensitivity
on accounting quality within their cross country sample, by partitioning observations in two
groups based on the prevalence of public equity versus debt financing (p.965). The authors found
that higher accounting quality is associated with lower investment-cash flow sensitivity that
depend more on publically equity financing compared with those more reliant on debt financing
(p.965). In addition, Biddle and Hilary examined the effect of accounting quality on investment
efficiency the firm-level in two selected countries—the U.S. and Japan (p.965). The authors
found that accounting quality matters both statistically and economically in the U.S., where
higher quality accounting is associated with lower investment-cash flow sensitivity, but did not
observe such a relation in Japan (p.965). In general, Biddle and Hilary’s study provided
empirical evidence that accounting and other institutional features relate to the economic
fundamentals of firm-level capital investment efficiency (p.965).
On the other hand, Brous and Datar (2007) investigated the market’s reaction to the
announcement by firms to voluntarily begin expensing stock-option based compensation. Brous

and Datar’s study was motivated by the action by firms to begin expensing their employee
granted options as the Financial Accounting Standards Board’s ruling requiring the expensing of
employee stock options (ESOs) appeared eminent by the summer of 2002 (p.252). The authors
noted three possible market reactions associated with the decision by firms to voluntarily
expense their ESOs:
1. The market did not react
2. The market reacted negatively based on the negative effect on reported earnings
3. The market reacted favorably due to either a positive received signal relating to
management’s willingness to increase transparency or a positive received signal
indicating that the reporting firms plans to reduce the excessive use of ESOs. (p.252)
Brous and Datar (2007) noted the strong theoretical arguments suggesting that the
recognition of the expense associated with ESOs will have no effect on the value of the
announcing firm (p.253). Specifically, Brous and Datar noted the argument that pro forma
earnings adjusted for the cost of ESOs are disclosed already in footnotes to financial statements
for years and, therefore, according to the semi-strong form of the efficient market hypothesis,
information relating to a firm’s cost for granting ESOs is already incorporated within the firm’s
stock price (p.252). In addition, the authors noted that the argument suggesting that the basic
discounted cash flows valuation theory suggests that expensing ESOs should have no effect on
the value of a firm because such cost represents a purely accounting issue that has no effect on
the operations of a firm or future cash flows generated by the firm (p.252). Moreover, the authors
noted the high tech industry’s concern regarding that the expensing of ESOs will have adverse
effects on earnings and, therefore negatively impacting the value of firms (p.252). Nevertheless,
Brous and Datar noted that the market could view the firm’s decision to voluntarily expense

ESOs favorably as the firm’s willingness to increase transparency in light of major corporate
financial scandals that were related to transparency issues (p. 253).
During the study, Brous and Datar (2007) collected a sample of 113 firms that planned to
begin voluntary expensing their granted ESOs (p.253). In addition, Brous and Datar applied a
regression analysis to test the validity of the hypotheses developed in their study (p.253). Brous
and Datar’s findings suggested that the voluntary decision by firms to recognize the cost
associated with granting ESOs is value enhancing. In addition, Braun and Datar noted that in
order to gain understanding of the underlying cause of the market’s reaction to the voluntary
announcement to start expensing costs associated with granting ESOs, a regression analysis was
used to determine whether firm specific characteristics were related the firms’ announcement
periods’ abnormal returns (p.261). The authors found a strong negative relation between the
announcements period’s returns and the expected effect on earnings per share, which provided
strong evidence against the argument that recognizing the expense associated with ESO grants
could be value destroying because of the resulting decrease in reported earnings (p.263).
Therefore, Brous and Datar’s study supported the view that the market values transparency in
reported earnings as opposed to the notion that expensing ESOs will be value destroying to the
high-tech industry (p.264).
Likewise, Chuk (2013) performed an empirical study to provide evidence of the
economic consequences argument by examining whether firms alter behavior in response to
changes in accounting standards that mandate new financial statement disclosures. Chuk’s study
was motivated by the limited amount of evidence supporting the impact of disclosure rules on
firm behavior (p.396). In establishing evidence supporting the impact of disclosure rules on firm
behavior, Chuk evaluated the economic consequences of mandated disclosures of pension assets

composition under SFAS 132 R (p.396). Understanding how the disclosure requirements under
SFAS 132 R affect firm behavior is economically important because the assumptions underlying
reported assets affect reported net income or loss (p.396). For example, assuming all else equal,
the higher the expected rate of return (ERR) the higher the reported net income and vice versa
(p.396).
In the study, Chuk (2013) predicted that the disclosure of asset allocations limit firms’
ability to manage earnings using ERR (p.396). Specifically, Chuk hypothesized that firms using
upward biased ERRs responded to SFAS 132 R requirements by a combination of increasing the
proportion of pension assets allocated to high risk investments and reducing the inflated ERR to
reflect the riskiness of the investments (p.396). In addition, Chuk predicted that the magnitude of
such behavior depended on the extent that pre SFAS 132 R ERR was inflated (p.396). Therefore,
Chuk developed a proxy to measure the extent that ERR was inflated by regressing ERR and the
proportion of pension assets allocated on various asset securities (p.396). The assumption was
that SFAS 132 R reduced the ability of firms to report ERRs that are unexplained by their
pension asset compositions and therefore there should be a greater alignment between ERR and
asset allocation in the post SFAR 132 R period (p.396). Chuk’s findings indicated that when the
disclosure of asset composition was required for the first time under SFAS 132 R, firms whose
reported ERRs were higher than justified by the composition of their pension plan asset
investment allocations alter their behavior by increasing their pension assets investments
allocated to high risk securities and or reducing their ERR values (p.397). In addition, Chuk
found that the magnitudes of both behaviors were positively associated with the upward bias
during the pre SFAS 132 R period (p.397). Thus, Chuk’s findings are consistent with the

argument that firms are willing to take real actions in order to report favorable financial
accounting information (p.397).
In addition, Sun (2014) examined the relation between the quality of financial reporting
and the efficiency in capital allocation. Sun’s study was motivated by the findings on previous
literature that ineffective monitoring and information asymmetry may cause the lack of capital
movement in response to changes in investment opportunities (p.1). Sun noted that while prior
research in finance focused primarily on the effect of financial market development on capital
allocation efficiency—while using accounting quality as a proxy, the direct impact of the quality
of financial accounting information on capital allocation decisions was not addressed (p.1).
Therefore, Sun’s study investigated how the quality of financial accounting information is
related to capital allocation decisions (p.1). In the study, Sun defined capital allocation efficiency
as the movement of capital into projects with increasing profitability and out of projects with
declining profitability (p.1).
To understand the concerned relationship, Sun (2014) developed a hypothesis that an
economic entity will have a higher growth rate if capital investments within the economy can
move into projects with higher returns and out of projects with low returns faster and in large
amounts (p.2). In addition, Sun noted that financial reporting improved capital allocation
decisions through efficient monitoring and a lower cost of capital (p.2). Specifically, Sun
explained that financial reporting quality determines the efficiency of monitoring—meaning the
higher the quality of financial reports, the efficient monitoring there is (p.2). In addition, Sun
noted that using reliable financial information as a direct input in contracting provides a less
biased performance measure that helps to reward managers for allocating capital into profitable
projects (p.2). Moreover, Sun noted that financial accounting information facilitates monitoring

through an informed market, which leads to a better monitoring of managers by shareholders
(p.2). On the other hand, Sun noted that financial reporting quality affects capital allocation
decisions through the cost of financing because firms with limited financing sources pass good
investment projects because inadequate information keeps uninformed investors out of the
financing markets (p.2).
To measure capital allocation, Sun (2014) calculated the capital allocation efficiency, β,
which was defined as an economy’s relative magnitude of investing in projects with increased
profitability and withdrawing investments from projects with low profitability, where a high β
meant a more efficient capital allocation (p.3). To measure financial reporting quality, Sun used
four variables:
1. Financial accounting transparency (INFO)
2. Governance transparency (GOV)
3. Financial statement disclosure index (CIFAR), and
4. Financial reporting quality (AUDIT). (p.3)
Sun (2014) obtained the first two measures of financial reporting quality from the study
by Bushman, Piotroski, and Smith (2004), while CIFAR was an index compiled by the Center of
International Financial Analysis and Research in 1993 and the AUDIT measure was the
percentage of firms audited by a “Big 6” accounting firm in a country (p.3). Sun hypothesized
that countries with better financial reporting will have a higher β (p.4). Therefore, Sun evaluated
a sample of 28 countries that had data available on all the four measures of financial reporting
quality and country-level control variables, as well as at least 10 years of investments in fixed
assets and value added data in the Industrial Statistics Database (INDATA) (p.5).

Sun (2014) found that INFO, GOV, the CIFAR index, as well as AUDIT were all
positively related to capital allocation efficiency (p.7). Therefore, Sun concluded that both
financial information transparency, the amount of disclosure, and audit quality improves
sensitivity to investment opportunities within an economy (p.7). Thus, financial information
transparency, the amount of disclosure, and audit quality improves capital allocation efficiency
within a country (p.10).
Arguments against Expensing ESOs and SFAS No. 123 R Implementation
Kulatilaka and Marcus (1994) stipulated that conventional option pricing models are not
well suited for the valuation of ESOs as ESOs are non-transferable and therefore may be
exercised early (p.46). To demonstrate the inapplicability of conventional option pricing models
in valuing ESOs, Kulatilaka and Marcus (1994) developed an option valuation model that took
into account the propensity of early exercise of ESOs and demonstrated that ESOs may be worth
much less than would otherwise be suggested by conventional pricing models, the values of
ESOs are sensitive to variables that do not appear in conventional option pricing models, the
values of ESOs may fall when the volatility of the underlying stock’s price increases, and that
the values of ESOs can be less than the minimum option values that appear in accounting
literature (p.46). The authors noted that while FASB’s exposure draft recognized the potential of
early exercise of ESOs and proposed that ESOs be valued using traditional option valuation
models such as the Black-Scholes, but the expected exercise replace the stated maturity of a
traditional option, estimating the estimated time to maturity is challenging and unreliable,
because; exercise experience depends on a large part on stock returns and stock returns may vary
considerably with time (p. 47). Nevertheless, the authors note that option values are quite

sensitive to assumed option lives, thus making the option values derived from historical exercise
experience further unreliable (p. 47).
To illustrate early exercise of ESOs, Kulatilaka and Marcus (1994) used a two-period
example that highlighted some of the pitfalls that may arise when ESOs are valued using the
expected terms using conventional option pricing models (p.47). Using the examples, the authors
demonstrated how incidences of early exercise depends on the path the underlying stock’s price
takes subsequent to the grant of options, making expected exercise rates of little use as such rates
are tied to market performance during relevant periods but are not necessarily predictive of
future prices of the underlying stock. Therefore, Kulatilaka and Marcus proposed the use of a
binomial model for valuing ESOs as such model can be used to calculate the expected time until
exercise of the ESO, given the probability distribution of future stock prices of the underlying
stock (p. 49).
On the other hand, Dechow, Hutton, and Sloan (1996) evaluated the economic
consequences of accounting for stock based employee compensation in the U.S. Their study was
motivated by the predictions of dire economic consequences and prompted regulatory
intervention within the accounting standard setting process by Congress and the White House
that exploded as a result of FASB’s 1993 Exposure Draft that proposed the recognition of
expenses associated with employee stock option (ESOs) grants on the income statement (p.1). To
evaluate the economic consequences of the Exposure Draft, the authors employed three
contemporary research approaches: First, the authors examined the characteristics of firms that
lobbied against the 1993 Exposure Draft, then they examined the characteristics of firms that
accounted for ESOs under the original financial reporting rules, and finally, they examined the
stock price reactions to announcements concerning the adoption of the new accounting rule (p.1).

To accomplish their research, Dechow et al. hypothesized that firms in which top executives
were heavily compensated through ESO grants were more likely to lobby against FASB’s
mandatory expensing of ESOs, that firms that were cash constrained and therefore compensated
their employees using ESOs were more likely to lobby against ESO expensing as they were more
likely to experience negative stock price reactions to events that increased the probability of the
mandatory expensing of ESOs , and that firms facing tight retained earnings-based debt
covenants were more likely to lobby against mandatory expensing of ESOs (pp.5-6). Dechow et
al. authors then evaluated a sample of firms that were more likely to be affected by certain
economic results of expensing ESOs from a group of firms that submitted comment letters to the
FASB in opposition of the Exposure Draft.
Dechow et al. (1996) found that their results were consistent with the hypothesis that
opposition to the expensing of ESOs arose from concerns of potential costs stemming from
reporting higher levels of top-executive compensation (p.2). In addition, the authors found no
systematic support for the claim that expensing ESOs would increase the cost of raising new
capital by reducing reported earnings (p.2). Therefore, the authors concluded that their results
were consistent the cost of capital argument being a political excuse to disguise top-executives’
self interested concerns with the new financial reporting rule (p.2).
In another study, Hagopian (2006) published a position paper opposing FASB’s Revised
Statement of Financial Accounting Standards No. 123 (SFAS 123 R) requiring employee stock
options (ESOs) valued at the date of grant and expensed over the vesting period of the option. In
the study, Hagopian noted a number of signatories opposing FASB’s position as they believed
that the expensing of ESOs is an improper accounting method that leads to serious impairments

of financial statements of companies that are heavy users of broad-based option plans (p139).
Hagopian noted that expensing ESOs is improper because:
1. Any ESO is a gain sharing instrument in which shareholders agree to share their gain,
if any, with employees
2. A gain sharing instrument should have no accounting costs unless the gain is shared
3. The costs of the gain sharing instrument must be recorded in the books of the party
that reaps the gain
4. For ESOs, the gain is reaped by shareholders not the firm
5. Therefore, the cost of ESOs is borne to shareholders and not to the firm
6. That cost to shareholders is already accounted for under the treasury stock method of
accounting as described by Financial Accounting Standards 128, Earnings per Share
(FAS 128). (pp.139-146)
Therefore, Hagopian (2006) concluded that while ESOs may result to a cost to
shareholders, granting them should not result to an expense to the granting firm (pp.14-147).
Thus, Hagopian characterized the mandate of expensing ESOs as one of the most radical changes
in accounting rules and standard setters should have not implemented the mandate without
absolute certainty that the usefulness of financial statements would be enhanced (p.146).
On the other hand, Ronen (2008) suggested the use of three separate financial statements
to better meet the needs of a corporation’s creditors and equity investors rather than including
share-based payment expenses in the statement of net income or loss (p.437). The motivation of
Ronen’s study was the publication of the Statement of Financial Accounting Standards (SFAS)
No. 123 R on December, 2004 that significantly changed the accounting for employee stock
options (ESOs). In the study, Ronen noted that the proposed expensing of stock options or grants

to employees is not responsive to either the needs of a corporation’s creditors or equity investors
as the cost of share-based payments is conceptually borne only to pre-existing shareholders as
the corporation suffers no sacrifice in assets or other resources (p.37). Therefore, Ronen
proposed the use of a corporate income statement, a statement of costs and benefits to pre-
existing shareholders, and a combined statement of enterprise income (p.439). According to
Ronen, the proposed corporation statement of income should not include share-based payment
expenses, but rather such payments should culminate within the other proposed statement—the
statement of costs and benefits to pre-existing shareholders (p.437). Ronen argued that including
the cost of share-based payments only in the statement of costs and benefits to pre-existing
shareholders will show the dilution costs that if accrued each year during the vesting period until
exercise, will cumulatively sum to the intrinsic value at exercise (p.437). In addition, Ronen
noted that the combined statement of enterprise income will report the totals from the other two
statements to reflect the net income from operations with regard to both the corporation and its
pre-existing shareholders (p.437).
Ronen (2008) demonstrated the proposal by providing a benchmark case illustrating the
effects of three consecutive annual ESO grants that vest prior to the end of each of the three
years, along with an asset manufactured and sold in the first to three years with proceeds
invested on the following year (p.439). In addition, Ronen added debt to the example to illustrate
how the proposed multiple statements better inform creditors and shareholders about gains and
losses accruing on their respective investments (p.439). Finally, Ronen generalized the insights
gained from the illustrations to debate the accounting treatment of ESOs. Therefore, Ronen’s
study demonstrated the need for presenting the effects of dilution costs suffered by pre-existing
shareholders through the granting of share-based payments on a separate financial statement

other than the traditional statement of income or loss as doing so will distinguish the costs to the
corporation and the costs to pre-existing shareholders and will highlight the dilution effects of
granted share-based payments (p.469).
Analysis
The Real Costs of Issuing ESOs
Bens, Nagar, and Wong (2002) examined whether the awarding of employee stock
options imposes real costs to granting firms by focusing on the cost implications of the practice
by managers of repurchasing shares in order to mitigate dilution effects of ESO exercises. From
their study, Bens et al. concluded that firms are likely to incur opportunity costs in terms of
foregone investment opportunities that result from ESO exercises due to the propensity of
managers to employ internally generated funds to repurchase shares for mitigating EPS dilution
effects. Likewise, Marquardt (2002) explored the existence explored the existence of ex-post
costs to firms issuing employee stock option grants and weather the Black-Scholes model
provides reasonable estimates of such costs. Marquardt’s findings presented empirical evidence
on the ex-post costs of ESOs to issuing firms and concluded that the Black-Scholes model
provides reasonable estimates of those values. Thus, both studies agreed that ESOs have
potential real costs to issuing firms.
Other ESO Pricing Models besides the Black-Scholes Model
The literature has identified a number of models that can be useful for valuing ESOs. For
example, Cuny and Jorion (1995) noted that simply multiplying the Black-Scholes option price
with the probability of departure ignores the possibility that executive departure is less likely
when the stock price is high (p.193). As a result, Cuny and Jorion identified a positive
correlation between the number of options exercised and the firm’s stock price and concluded

that any complete analysis of ESO values should consider both high ESO values due to the
positive correlation between a firm’s stock price and executive departure, as well as other feature
that make the valuation of ESOs different from that of traded stock options.
In addition, Carpenter (1998) introduced another model for valuing ESOs that extended
the ordinary American option model to include random, exogenous exercise and forfeiture
characteristics. Similar to concussions made by Cuny and Jorion (1995), Carpenter noted that
understanding the exercise decisions of executives is important for estimating values of ESOs.
However, Carpenter’s findings suggested that a simple extension of the usual binomial model for
valuing traded options can be adequate for valuing ESOs as no case of a utility-maximizing
model outperforming a simple extension of the American option valuation model was identified
when results from models of varying sophistication were compared.
Alternatively, Hull and White (2004) proposed an ESO valuation model that explicitly
considered the possibility that employees could leave the company after the vesting period and
explicitly incorporated the employees’ early exercise policy by assuming that early exercise
happens when the company’s stock price reached a certain multiple, M of the stock price (p.116).
Hull and White noted that the value of M could be estimated through calculating the average
ratio of the stock price to the strike price that employees have made decisions to exercise their
ESOs in the past and such decisions were not made immediately after the vesting period (p.116).
Likewise, Bulow and Shoven (2005) agreed with previous literature that the valuation of
ESOs should differ from that of traded stock options due to some specific features of ESOs that
are not applicable to traded options, Bulow and Shoven proposed a valuation model that
accounted for ESOs as 90 day options that are extended for 90 days at the beginning of every
quarter of employment. Bulow and Shoven 90 day proposal reasoning was due to the observation

that most employees typically exercise or forfeit their ESOs within 90 days following the
termination of employment. Bulow and Shoven noted that their valuation model better achieved
financial accounting objectives of decision relevance, robustness, transparency, simplicity,
comparability, and reliability as ESO expenses after the grant quarter depended on the current
price of the company’s stock, rather than the grant date value.
Additionally, Anderson and Brisley (2008) introduced a µ model, which assumed that
employees exercise voluntarily whenever the extent that the ESO is in the money reaches a fixed
proportion µ of the remaining Black-Scholes value (p.89). While Anderson and Brisley’s
findings agreed with previous literature that the use of lattice-form valuation models is better
suitable for valuing ESOs than the Black-Scholes variants, Anderson and Brisley noted that
lattice-form models are still imprecise for ESO valuations. Therefore, Anderson and Brisley’s µ-
model took into account the early exercise tradeoff between the intrinsic value captured and the
opportunity cost of the option value foregone throughout the ESOs life, which made the
estimation of the µ parameter from the observation of early exercises less prone to bias caused
by atypical stock price histories.
The Economic Consequences of Expensing ESOs
Studies within the literature appear to agree that quality financial reporting has positive
economic consequences. For example, Rappaport (1997) noted that financial accounting
standards can affect behavior within an economy through affecting the behavior of intended
recipients of corporate financial reports, by affecting the behavior of those who are not directly
intended to but do gain access to corporate financial reports because the reports are publically
accessible, and by affecting the behavior of reporting firms such that in anticipation of
potentially adverse reactions from recipients of corporate financial reports, the reporting firm

chooses to alter its economic behavior (pp. 89-80). Likewise, Zeff (1978) noted that the resulting
behavior of such users of corporate financial information could be detrimental to interests of
other affected parties and thus standard setters should consider such consequences when
proposing accounting standards and actions (p. 56).
Similarly, Bhattacharya, Daouk, and Welker (2003) analyzed financial statements from
34 countries for the period 1984 to 1998 to construct a panel data-set measuring three
dimensions of reported accounting earnings for each country and hypothesized that those three
dimensions of reported accounting earnings for each country were associated with uninformative
or opaque earnings. From the study, Bhattacharya et al. found that the estimates of average
earnings opacity per country were significantly associated with variables that could impact the
overall quality of a financial reporting regime of a country. Thus, Bhattacharya et al concluded
that the quality of a financial reporting regime has real economic consequences to a country.
In addition, Graham et al. (2005) found through interviewing a broad group of CFOs that
CFOs view earnings as more important than cash flows (p.65). The conclusions by Graham et al.
were supported by findings by Biddle and Hilary (2006) that accounting and other institutional
features relate to the economic fundamentals of firm-level capital investment efficiency (p.965).
Similarly, Brous and Datar (2007) supported the view that the market values transparency in
reported earnings after identifying a positive reaction by the market to the announcements by
firms to begin voluntarily expensing stock-option based compensation (p264). Likewise, Chuk
(20130 found that firms are willing to take real actions in order to report favorable accounting
information, while Sun (2014) concluded that both financial information transparency, the
amount of disclosure, and audit quality improves cash sensitivity to investment opportunities
within an economy.

The Case against Expensing ESOs
Arguments against expensing ESOs mainly focus on the limitations associated with ESO
valuation models, the potential hit on earnings from a cost that cannot even be reliably estimated,
and the negative consequences that the expensing of ESOs could have on the overall economy
and particularly to industries with heavy ESO issuers such as the high-tech industry. For
example, Kulatilaka and Marcus (1994) argued that expensing ESOs is not correct as
conventional ESO valuation models are not suited for the valuation of ESOs since ESOs are non-
transferable and therefore can be exercised early (p.46). In addition, Hagopian (2006) noted that
expensing ESOs is improper because ESOs are gain sharing instruments which shareholders
agree to share the gain, if any, with employees and the cost associated with any gain sharing
instrument should be recorded on the books of the party that reaps the gain, which implies that
ESO costs should not be recorded on the books of the firm issuing the ESO.
Conclusion
The purpose of the study was to determine whether the expensing of ESOs results to
incorrect earnings and whether doing so could have any negative economic consequences. To
accomplish the purpose of the study, the research focused on evaluating the merit of FASB’s
decision to include the cost of granting ESOs on an organization’s income statement and
evaluating the logical constructs of the main arguments paused by the opponents of FASB’s
decision to require firms to estimate their costs of granting ESOs to employees and including that
estimated cost on financial statements as a deduction from earnings.
The Real Costs of Issuing ESOs
The literature review suggested that ESOs impose real costs to issuing corporations. For
example, Bens, Nagar, and Wong (2002) study found that corporations incur opportunity costs in

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