ESO Flashcards
What is the main argument of Guay, Kothari, and Sloan (2003) regarding ESOs?
Employee stock options (ESOs) are a real cost of labor and should be expensed in financial statements.
What two components make up an ESO transaction according to the authors?
- Financing activity (issuing warrants to employees), 2. Operating activity (paying for labor).
Why is not expensing ESOs problematic for EPS calculations?
It inflates reported earnings, leading to a misleading EPS even if share dilution is included.
What example do the authors use to show the distortion in EPS from not expensing ESOs?
Two firms with identical economic returns report drastically different EPS if one expenses ESOs and the other doesn’t.
What is the ‘dilution argument’ against expensing ESOs?
That ESO cost is already reflected in EPS through dilution in the denominator.
How do the authors refute the dilution argument?
Dilution only affects the EPS denominator; failing to expense ESOs overstates the numerator.
Why do some argue ESOs are hard to value?
Due to features like vesting, non-transferability, and early exercise.
How do the authors address valuation concerns of ESOs?
They argue ESO valuation is no more complex than pensions or R&D expense estimates.
Why is the employee’s risk aversion not relevant in ESO accounting?
Because accounting should reflect the firm’s cost, not the employee’s perceived value.
What economic consequences are feared by opponents of expensing ESOs?
Lower stock prices, higher capital costs, and reduced innovation.
How do the authors challenge the claim that markets will misprice expensed ESOs?
Empirical research shows investors do use ESO disclosures and are not irrational.
What governance issue do the authors highlight related to ESOs?
That not expensing ESOs allows executives to hide excessive compensation, especially in poorly governed firms.
What empirical evidence supports the governance argument?
Firms that lobbied against expensing paid more in options, had weaker governance, and favored top executives.
What are some contracting-related concerns of expensing ESOs?
Triggering debt covenants, losing customer trust, and possible IRS taxation at grant instead of exercise.
What is the authors’ stance on politics and accounting rules?
Accounting should reflect economic reality, not be shaped by political or corporate lobbying.
What is meant by ‘barter transaction’ in the context of ESOs?
Labor services are exchanged for equity, and both sides of the transaction need to be accounted for.
Why do the authors advocate for expensing ESOs at the grant date?
To reflect the true cost of labor and provide consistent, transparent financial reporting.
What happens if ESO value is marked to market over time?
It could introduce volatility in earnings not matched by asset valuations, leading to confusion.
What is a fair value model commonly used for ESO valuation?
Black-Scholes option pricing model.
What is the main conclusion of the paper?
ESOs should be expensed to reflect true business costs and support informed decision-making by stakeholders.
