Are Companies Inflating Earnings & Equity by Granting Employee Stock Options?

Open Access
Author:
Frazier, Charles William
Area of Honors:
Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Jingzhi Huang, Thesis Supervisor
  • Jingzhi Huang, Honors Advisor
Keywords:
  • Employee stock options
  • employee
  • stock
  • option
  • ESO
  • earnings
  • equity
  • accounting
  • IPO
  • initial public offering
  • contingent liability
Abstract:
The issue of how to report the impact of Employee Stock Options (ESO) to shareholders has been a fiercely contested debate in the business community for decades, with hundreds of billions of dollars of compensation and potential expense in question. The Financial Accounting Standards Board (FASB) made significant progress by finally requiring the expensing of ESOs under ASC 718, but the standard has flaws that are causing shareholders to receive reported earnings and equity that are significantly misstated. Earnings are misstated due to loss that occurs at the exercise of an ESO that is never recorded as an expense, and equity is misstated by both the cumulative effect of these unrecorded losses, as well as the improper practice of recorded ESOs on the balance sheet as increases to equity. The purpose of this undergraduate honors thesis is to analyze the magnitude and impact of these misstatements. A case study of Apple Inc. shows that these misstatements can be significantly large and can persist over significantly long periods of time, and an Initial Public Offering (IPO) case study shows that the impact is amplified by the dramatic share price changes that occur during an IPO. I recommend an alternative method of accounting for ESOs that would fully disclose the impact to shareholders. I also discuss the necessary yet drastic changes required to adopt this new method and the challenges that will need to be overcome to make the changes.