Financial Reporting for Employee Stock Options: The Importance of Differentiating Compensation from Proceeds

Prior research finds a negative relation between outstanding employee stock options (ESOs) and common equity risk, suggesting that outstanding ESOs share characteristics with equity rather than liabilities. We extend this research to examine whether this relation is attributable to (1) the expected value of the cash proceeds to be received upon ESO exercise (“ESO-Proceeds”), or (2) the expected value of compensation to be paid to ESO holders for services provided (“ESO-Compensation”). This distinction is important because the question of whether outstanding ESOs share characteristics with liabilities or equity inherently pertains to ESO-Compensation, not ESO-Proceeds. Our findings indicate that the negative relation observed in prior research is attributable to ESO-Proceeds rather than ESO-Compensation, which is inconsistent with ESOs possessing characteristics of equity. Our study illustrates the importance of differentiating ESO-Compensation from ESO-Proceeds when addressing financial reporting questions related to outstanding ESOs.