Question

QUESTION:

Expensing of employee stock options (ESOs) is now a requirement in financial reporting both under U.S. GAAP and IFRS. However, management, especially in the United States, successfully resisted expensing for many years before the expensing rules were finally adopted. Even now, accounting for ESOs remain a controversial topic.

Required

    a. Evaluate the relevance and reliability of ESO expenses when calculated using the Black/Scholes formula or a similar model.

b. Researchers have observed that managers compensated by ESOs tend to release bad news prior to ESO grant dates and good news prior to ESO exercise dates. Discuss the incentives of managers to choose this timing for release of bad and good news.

c. One noteworthy feature about the fair value of an ESO is that its lowest value is zero when the price of the underlying stock is less than the exercise price. On the other hand, the value of an ESO can be very high when the price of the underlying stock is significantly higher than the exercise price.

                                                Discuss the effect of this asymmetric feature of ESOs on managers’ incentive to undertake risky projects. In other words, do these features lead to managers undertaking high-risk projects or low-risk projects?

Answer 1

a. ESO expenses are relevant to predict the future cash flows of the firm by the investors. It is relevant because the future firm dividends will be spread over the stocks issued through ESO's.

Usually ESO expenses calculated using Black / Scholes model do not tend to be reliable since it causes an upward bias in the ESO expense. As per Black/ Scholes it is assumed that the stock options are held to maturity which makes it necessary to have an estimated exercise date. The estimate may not be accurate and can have bias.

b. The release of good news or bad news is a way to influence stock prices by the managers. The announcement of a bad news will certainly lower the stock prices and the ESO exercise price will be lower as it is set at the stock price on the grant date. A lower exercise price is always helpful for the managers since the cash inflow from the ESO's and the sale of the ESO's after exercising the options will be higher. They tend to never release the impending good news since it will increase the share price and the benefits will not be maximized.

c. Taking excessive risk by the managers will lead to lower share prices and hence benefits the managers through cash inflow and later sale of the stock options. A high risky projects implies that the firm is relying more than debt than equity which will lead to sub optimal capital structure policies. Having higher debt will reduce the retained earnings and thereby causing the share price to drop since the firm did not deliver the expected earnings by the market.