Employee Stock Options And Diluted Earnings Per Share: An Extension

Abstract

Firms must currently apply the fair value method in determining the amount of employee compensation incurred in the case of employee stock options.   The amount of such compensation is required to be measured as fair value of the equity instrument at the grant date, with compensation expense recognized over the service period under the straight-line method.  This compensation expense affects the numerator for purposes of calculating earnings per share (EPS) under generally accepted accounting principles (GAAP).  Current GAAP also requires that for purposes of calculating diluted EPS, the treasury stock method be applied where the assumed proceeds from exercise of the optioned shares is used to purchase shares of the firm’s stock at its average market price of the earnings period.  These incremental shares increase the denominator for purposes of calculating diluted EPS.  These requirements are consistent across the pronouncements of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).  This study extends the work of Doran (2005) where a single period model was assumed and found: 1. Application of the fair value method does not double count the impact of compensation recognized, and 2. Applying the treasury stock method where shares are assumed purchased at the average for the period price (instead of end of year price) understates the number of incremental shares (the denominator), which overstates diluted EPS.  This paper employs a simple multi period model that assumes a risk free environment with complete certainty in testing the accuracy of GAAP compliant diluted EPS in the case of employee stock options.  Consistent with Doran (2005) the results here again indicate that assuming purchase of treasury shares at their average market price of the earnings period understates the EPS denominator. The results of this study also indicate that the reported employee compensation expense is understated.  The observed cause of this numerator error is treating the “payment” for the option (employee service) as if it was received in full at the grant date - as a lump sum (like inventory or some other asset), rather than being received ratably over the employee service period – as an annuity.  Each of these findings contributes to the observed overstatement of diluted EPS.  Correct diluted EPS is observed when the employee service is treated as being received ratably over the service period, and the shares assumed purchased as treasury stock are acquired at the higher period ending market price.  The amount of diluted EPS overstatement under both FASB and IASB standards is directly related to the length of the term of the option.