This paper compares the extent to which the accounting methods specified by APB No. 25, SFAS No. 123, and the Exposure Draft reflect the market's assessment of the effects of employee stock options (ESOs) on firm value, using the Feltham and Ohlson (1999) valuation model for a sample of 85 profitable computer software firms. For each method we estimate abnormal earnings and valuation equations. The fundamental question we ad-dress is whether investors view profitable software firms' ESO expenses similarly to other expenses.
Findings from estimating equations under the SFAS No. 123 approach (which requires only disclosure of the ESO expense) indicate that similar to other expenses, current ESO expense forecasts lower abnormal earnings in the subsequent year. However, contrary to the Ohlson (1999) model's prediction given a negative relation between current ESO ex-pense and future abnormal earnings, investors appear to value ESO exex-pense as an asset.
One explanation is that the SFAS No. 123 models omit an intangible asset. Findings from estimating equations under the Exposure Draft approach (which would have required rec-ognition of an ESO asset as well as an ESO expense) suggests that investors perceive the ESO asset as value-relevant. In addition, our results suggest that investors value this asset more highly than they do other net assets of the firm, which is consistent with employee stock options creating a valuable intangible asset (i.e., contributed intellectual capital). In-terestingly, our results suggest that investors continue to value ESO expense as an asset even when we include the amortized ESO asset in the valuation model. This result suggests that the amortized ESO asset may not capture fully the future net economic benefit of employee stock options. When we repeat this analysis using the unamortized (gross) ESO asset, the ESO asset remains value-relevant while ESO expense does not, which is consistent with the market expecting the ESO asset to have a useful life longer than the option-vesting period.
We interpret our results based on the market-efficiency assumption. However, we find a conflict between the positive manner in which investors value ESO expense vs. the neg-ative relation between ESO expense and future abnormal earnings. This finding calls into question whether investors in profitable software companies assess the effect of employee
18 We also estimated Equation (4a) including SG&A as a separate regressor. As with the valuation equation, untabulated findings indicate that SG&A has a negative total coefficient, significant in 1997 and for the pooled sample.
stock options correctly. Another explanation is that our simple first-order autoregressive structure for abnonnal earnings is not descriptively valid for ESO expense. We also interpret the study's results assuming that we measure the ESO accounting variables without error, even though firms understate ESO expense in our first two sample years.
Taken together, we interpret our study's findings as suggesting that the Exposure Draft approach to accounting for stock options best captures the market's perception of the ec-onomic effect of employee stock options on profitable computer software firm value. Most notably, the results suggest that investors in profitable software companies perceive that employee stock options create an intangible asset that they value more highly than other assets of the firm. This is consistent with employee stock options playing an important role in employee attraction, motivation, and retention (Ittner et al. 2002) in knowledge-intensive industries. We leave it to future research to determine the extent to which our findings generalize to firms in other industries or to nonprofitable entities.
REFERENCES
Aboody, D. 1996. Market valuation of employee stock options. Journal of Accounting and Economics 22 (August-December): 357-391.
, and B. Lev. 1998. The value-relevance of intangibles: The case of software capitalization.
Jouinal of Accounting Research 36 (Supplement): 161-191.
, M. E. Barth, and R. Kasznik. 2001. Stock-based employee compensation and equity market values. Working paper, Stanford University, Stanford, CA.
American Institute of Certified Public Accountants (AICPA), Accounting Principles Board (APB).
1972. Accounting for Stock Issuted to Employees. Accounting Principles Board Opinion No. 25.
New York, NY: AICPA.
Barth, M. E., W. H. Beaver, J. R. M. Hand, and W. R. Landsman. 1999. Accruals, cash flows, and equity values. Review of Accouinting Studies 4 (December): 205-229.
,1 - , 1 ,and - . 2000. Accrual components, earnings forecasting, and equity values. Working paper, The University of North Carolina at Chapel Hill, NC, and Stanford Uni-versity, Stanford, CA.
-1 ,1 and W. R. Landsman. 2001. The relevance of the value relevance literature for financial accounting standard setting: Another view. Journal of Accounting and Economics 31 (September): 77-104.
and G. Clinch. 2001. Scale effects in capital market-based accounting research. Working paper, Stanford University, Stanford CA.
Butsiness Week. 2002. Executive pay. (April 15): 80-100.
Chamberlain, S., and S. Hseih. 1999. The effectiveness of SFAS 123 employee stock option disclo-sures. Working paper, Santa Clara University, Santa Clara, CA.
Dechow, P. M., A. P. Hutton, and R. G. Sloan. 1999. An empirical assessment of the residual income valuation model. Jotunzal of Accounting and Economics 26 (January): 1-34.
The Economist. 1999. Share options. (August 7): 18-20.
Engel, M. 1997. Long-term incentive plans. In Paying for Peiformance, edited by P. T. Chingos, 176-209. New York, NY: Wiley.
Feltham, G. 1995. Valuation, clean surplus accounting, and anticipated equity transactions. Working paper, University of British Columbia, Vancouver, Canada.
- , and J. A. Ohlson. 1995. Valuation and clean surplus accounting for operating and financial activities. Contemporary Accounting Research 11 (Spring): 689-732.
, and . 1999. Residual earnings valuation with risk and stochastic interest rates. The Accounting Review 74 (April): 165-184.
Financial Accounting Standards Board (FASB). 1993. Exposure Draft: Accounting for Stock-Based Coompensation. Norwalk, CT: FASB.
* . 1995. Accounting for Stock-Based Compensation. Statement of Financial Accounting Stan-dards No. 123. Norwalk, CT: FASB.
Hall, B. 1999. Innovation and market value. In Productivity, Innovation, and Economic Performance, edited by B. Ray, G. Mason, and M. O'Mahoney. Cambridge, U.K.: Cambridge University Press.
, A. Jaffe, and M. Trajtenberg. 1999. Market value and patent citations: A first look. NBER Working Paper. Cambridge, MA: National Bureau of Economic Research.
Hall, B. J. 2000. What you need to know about stock options. Harvard Business Review (March-April): 121-129.
Hand, J. R. M., and W. R. Landsman. 2000. The pricing of dividends and equity valuation. Working paper, The University of North Carolina at Chapel Hill, NC.
Hayn, C. 1995. The information content of losses. Journal of Accounting and Economics 20 (Sep-tember): 125-153.
Ittner, C., R. Lambert, and D. Larcker. 2002. The structure and performance consequences of equity grants to employees of new economy firms. Journal of Accounting and Economics (forthcoming).
Keating, E., T. Lys, and R. Magee. 2002. The Intemet downtum: Finding valuation factors in spring 2000. Journal of Accounting and Economics (forthcoming).
Landsman, W. R., and A. C. Shapiro. 1995. Tobin's Q and the relation between accounting ROI and economic return. Journal of Accounting, Auditing, and Finance 10 (Winter): 103-118.
Morgenson, G. 1998. Stock options are not a free lunch. Forbes (May 18): 213-217.
Ohlson, J. A. 1995. Earnings, equity book values, and dividends in equity valuation. Contemporary Accounting Research 11 (Spring): 661-687.
1999. On transitory earnings. Review of Accounting Studies 4 (December): 145-162.
2000. Residual income valuation: The problems. Working paper, New York University, New York, NY.
Stewart, T. 1997. Intellectual Capital. New York, NY: Currency Doubleday.
Vuong, Q. H. 1989. Likelihood ratio tests for model selection and non-nested hypotheses. Econo-metrica.57 (March): 307-333.
White, H. 1980. A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity. Econometrica 48 (May): 817-838.
TITLE: The Valuation Implications of Employee Stock Option Accounting for Profitable Computer Software Firms SOURCE: The Accounting Review 77 no4 O 2002
WN: 0227404825012
The magazine publisher is the copyright holder of this article and it is reproduced with permission. Further reproduction of this article in violation of the copyright is prohibited. To contact the publisher:
http://accounting.rutgers.edu/raw/aaa/index.html.
Copyright 1982-2002 The H.W. Wilson Company. All rights reserved.