Stock option expense recognition and the cost of equity

Abstract

This study examines whether recognizing an expense on the face of the financial statements affects the cost of equity capital. Specifically, we analyze cost of equity effects around the change in accounting treatment imposed by Statement of Financial Accounting Standards 123R (SFAS 123R). This standard requires the recognition of an expense for the fair value of employee stock option grants, while previously this information was disclosed in financial statement footnotes. We find that, while pre-SFAS 123R firms benefited from a relatively lower cost of equity from option grants, once expense recognition was required, the benefit was diminished. While various possible explanations for this result exist, our additional analyses suggest that a decline in accounting information quality drives our results. Further, we find that the impact of SFAS 123R was greater for firms operating in technology-focused industries, likely due to their heavy use of stock options.