Managing Stock Option Expense: The Manipulation of Option-Pricing Model AssumptionsContemporary Accounting Research Johnston, D.
2006
Authors from the College of Business:
Derek Johnston, Associate Professor of Accounting, Bartels & Company Junior Research Fellow Contemporary Accounting Research
A relatively new accounting standard, FAS No. 123(R), requires public companies to report the cost associated with their employee stock option plans as an expense in the income statement. In following the rules set forth in FAS No. 123(R), a firm must estimate the fair value of the stock options granted to its employees during the year using an option-pricing model. The number of options granted multiplied by the estimated fair value is the stock option expense the company should report in its income statement.
Option-pricing models, such as the Black-Scholes model, require the firm to make assumptions about the life of the stock option, the volatility of the stock price, the risk-free interest rate, and the dividend yield. Since each of these assumptions affect the fair value of the stock options and, therefore, the related expense, a company can reduce its stock option expense (and increase its reported profits) by manipulating these inputs.
This is where my study comes into the picture. By comparing the option-pricing model assumptions used by the company to those assumptions constructed based solely on historical data, I found evidence that, on average, firms significantly understate stock option expense. In particular, the results suggest that companies manipulate the stock price volatility assumption in order to reduce the amount of the expense that hits the income statement. Since this paper provides evidence that firms many manipulate option-pricing model assumptions, the results may be of interest to capital market participants and accounting standard setters as it calls into question the reliability of the stock-based compensation expense that is reported in the financial statements.