SUMMARY

Current accounting standards require firms to recognize as an expense (deduct from their income) the value of the compensation they provide in the form of employee stock options. For some types of employee stock options they grant, however, firms can choose how to measure that value.

They can use the immediate-exercise value (intrinsic value), which is usually zero, or an estimate of the market value (fair value), which is almost always greater than zero. As a result, firms may assign a cost of zero to that portion of compensation made up of grants of employee stock options. That practice results in overstatement of reported net income.

In March 2003, the Financial Accounting Standards Board (FASB), the private-sector organization that sets standards for financial accounting and reporting in the United States, announced that it would reconsider the accounting standard for equity-based compensation. On March 31, 2004, FASB released an exposure draft that proposes revising the standard to require—not merely encourage— firms to recognize the fair value of all employee stock options as compensation expense for financialreporting purposes. The prospect of that revision has generated considerable debate.

Some analysts argue that requiring firms to recognize as an expense the fair value of employee stock options is unnecessary or ill-advised. Underpinning those arguments are different assumptions about whether the information on fair value is currently transparent to users of financial reports.

Analysts who believe that information about fair value is adequately transparent consider it unnecessary to change the current standard. Although information about fair value is not reflected in net income, it is already available to investors in the notes to firms’ annual financial reports. (In those notes, firms must disclose the fair value of the grants of employee stock options for which they recognized the intrinsic value.)

Other observers maintain that recognizing the fair value of employee stock options is ill-advised because that information is not now transparent and making it so could have negative consequences. Recognition might reveal new information to investors that could drive down the stock prices of firms that grant employee stock options. That result could in turn damage the economy, some analysts argue.

Still other analysts oppose the recognition of the fair value of employee stock options on more basic grounds. For example, they assert that the value of those options cannot be estimated reliably and that recognizing an estimate of the expense would reduce the accuracy of reported net income. Others oppose recognition because they do not view the granting of employee stock options as an expense to the firm at all but simply a redistribution of equity.

The Congressional Budget Office’s (CBO’s) analysis of this accounting issue comes to the following conclusions: ...

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The Congress of the United States
Congressional Budget Office

CONTENTS
Summary vii
The Key Issue: Intrinsic Versus Fair Value 1
The Current Accounting Standard 2
FASB’s Proposal 3
Why Firms Grant Stock Options 3
Potential Economic Effects of Fair Value Recognition 4
Valuing and Recognizing
Employee Stock Options 5
The Difficulty of Measuring the Value of
Employee Stock Options 5
When Should the Value of Employee
Stock Options Be Measured? 7
When Should the Expense of Employee Stock Options
Be Recognized? 8
Comparing Accounting Alternatives: An Example 8
Granting Cash, Stock, and Purchased Call Options as
Compensation 8
Granting Employee Stock Options in Lieu of
Equivalent Cash Compensation 10
Letting Options Expire or Exercising Them 11
The Bottom Line: Reporting Differences
Between the Two Accounting Methods 11

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