ACCOUNTING FOR EMPLOYEE STOCK OPTIONS AND MANDATORY EXPENSING: AN ECONOMICS PERSPECTIVE

Abstract

Whether employee stock options should be expensed at the grant date has been a highly controversial accounting issue. While the existing literature draws pro-expensing conclusions based on accounting principles and analogies, we shed new light to the issue by examine three functions of option granting in an analytical model. In principle, we show that while expensing is justified for financing options granted for expense postponement, it would misrepresent incentive options granted for long-term performance improvement. In practice, we show that options' fair value or the cost of granting them may not be the right amount to expense, and the inherent risk-sharing function of employee stock options poses a fundamental difficulty in estimating their fair value based on option pricing models. In conclusion, the findings of our examination do not support mandatory option expensing.