Disclosure versus Recognition of Option Expense: An Empirical Investigation of SFAS No. 148 and Stock Returns

Is quarterly employee stock option expense reported under the recently promulgated SFAS No. 148 value relevant? If so, is there a differential valuation effect related to the placement of the option expense within the financial statements, i.e., on the income statement or only in a footnote? Using a sample of 142 distinct firms (363 firm quarters) that recently began recognizing option expense voluntarily, and thus reported both disclosed and recognized option expenses, we find that whether the quarterly option expense is only disclosed in the footnotes, or whether it is also recognized in the income statement, the market values the cost associated with employee stock options as an expense. More importantly, we also find that the market valuation of that expense does not differ whether the amount is only disclosed in the footnotes, or whether it is also recognized in the income statement. Our findings are especially topical given the newly promulgated SFAS No. 123 (revised 2004), Share-based Payments. In this pronouncement, the FASB mandated income statement recognition for employee stock option expense for all firms starting (with a few exceptions) on June 15, 2005. By showing that market participants equally value the stock option expense whether it is disclosed or recognized, we show that firms need not worry about the first order effect of mandated recognition on their share prices.