Compared to the reported 2009 financial statements, if Stereo Warehouse had used the 2007 expected volatility assumption to value its employee stock options, it would have most likely reported higher:

A. net income.

B. compensation expense.

C. deferred compensation liability.

Stereo Warehouse is a US retailer that offers employees a defined benefit pension plan and stock options as part of its compensation package. Stereo Warehouse prepares its financial statements in accordance with US GAAP.

Peter Friedland, CFA, is an equity analyst concerned with earnings quality. He is particularly interested in whether the discretionary assumptions the company is making regarding compensation plans are contributing to the recent earnings growth at Stereo Warehouse. He gathers information from the company’s regulatory filings regarding the pension plan assumptions in Exhibit 4 and the assumptions related to option valuation in Exhibit 5.

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EXHIBIT 4 Assumptions Used for Stereo Warehouse Defined Benefit Plan 2009 6.06% 4.85 4.00 3.00 Expected long-term rate of return on plan assets Discount rate Estimated future salary increases Inflation EXHIBIT 5 Option Valuation Assumptions 2009 4.6% 5.0 yrs 1.0% Risk-free rate Expected life Dividend yield Expected volatility 29% 2008 3.8% 4.5 yrs 0.0% 31% 2008 6.14% 4.94 4.44 2.72 2007 6.79% 5.38 4.25 2.45 2007 2.4% 5.0 yrs 0.0% 35%