New Economy Accounting: Why Are Broad-Based Stock Option Plans So Attractive?

In recent years stock option plans have become a substantial part of compensation schemes in U.S. companies. While in the beginning companies granted options only to the top-management more and more companies offer broad-based stock option plans. For these plans more than 50 percent of the employees are eligible. It is well known that stock option plans are suitable to bring employees' interests in line with shareholders' interests, since due to these option plans their income is linked to shareholders' wealth. But it is still an open question why stock option programs are more popular than similar performance-based compensation schemes. This paper proposes an answer: Because of the actual accounting rules in the USA, companies are able to hide the labor-cost resulting from stock option plans. More precisely, the U.S. Generally Accepted Accounting Principles (US-GAAP) require no charge to earnings for specifically designed stock option plans if a company opts for footnote disclosure. Thus, using such stock option plans companies' earnings are higher than with similar performance-based compensation schemes, even though economically they are the same. Based on a case study of 20 companies out of the S&P 500 which rely heavily on employee stock options we arrive at the conclusion that the amount of hidden compensation cost can reach economically significant amounts. Hence, this hidden labor-cost component should not be neglected either by academic nor by applied investment research, since the analysis of a firm's earnings power may be considerably biased. But, this topic seems to be widely neglected and thus it is questionable whether stock prices reflect these hidden cost and whether academic research results are partly driven by this misrepresentation of earnings.

Hess, Dieter and Erik Lüders (2000), New Economy Accounting: Why Are Broad-Based Stock Option Plans So Attractive?, ZEW Discussion Paper No. 00-39, Mannheim.