Diluted Earnings Per Share Overstatement Bias: Including Unrecognized Employee Compensation In Proceeds From Assumed Exercise Of Employee Stock Options Under The Treasury Stock Method

Abstract

Generally accepted accounting principles (GAAP) require firms to recognize compensation expense under the fair value method in the case of employee stock options. Straight line amortization of the options grant date fair value must be recognized as expense over the service period which decreases the earnings per share numerator. For diluted earnings per share (EPS), GAAP requires using the treasury stock method, where proceeds from assumed stock option exercise is used to purchase treasury shares at the average for the period price. Exercise proceeds include the exercise price plus unrecognized future employee compensation. For profitable firms, exercise is assumed if dilutive - more shares are assumed issued than are reacquired for the treasury which increases the diluted EPS denominator. These requirements are consistent across US GAAP and International Financial Reporting Standards. This paper tests whether including unrecognized employee compensation in proceeds from the assumed exercise of employee stock options under the treasury stock method is appropriate. A simple multi period model that assumes a risk free environment with complete certainty is applied. This study contributes to the literature by demonstrating that future unrecognized employee compensation should not be included in proceeds from the assumed exercise of stock options under the treasury stock method. Doing so consistently causes diluted EPS overstatement, and in certain instances causes assumed exercise of in the money options to be antidilutive, which results in complete exclusion from the diluted EPS calculation. This research extends the employee stock option work of Doran (2005 and 2008) that found: 1) Compensation expense recognized over the employee service period should equal the periodic annuity amount that provides the options grant date fair value, and 2) Treasury shares should be assumed purchased at the higher end of period stock price.