In June 1993, the FASB issued an exposure draft of a proposed new standard regarding the accounting treatment of employee stock options (ESOs). The exposure draft proposed that firms record compensation expense based on the fair value at the grant date of ESOs issued during the period. Fair value could be determined by the Black-Scholes model or other options pricing formulas.

The exposure draft attracted extreme opposition from managers, who lobbied the U.S. Congress, expressing concerns about the economic consequences of the lower reported profits. Those claimed consequences included lower share prices, higher cost of capital, a shortage of managerial talent, and inadequate manager and employee motivation. This would particularly disadvantage small start-up companies that were heavy options users. To preserve their bottom lines, firms would be forced to reduce ESO usage, with negative effects on cash flows, motivation, and innovation. This, it was claimed, would threaten the competitive position of American industry.

Required

a. Consider the assigned article, “An Exchange Between the Honorable Edward J. Markey, Chairman, U.S. House of Representatives Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce and the Honorable Arthur Levitt, Jr., Chairman, Securities and Exchange Commission.”

i. With what theory of regulation are the arguments of U.S. Representative Markey most consistent? Explain your answer.

ii. With what theory of regulation are the arguments of SEC Chairman Levitt most consistent? Explain your answer.

b. Suppose that you were a member of FASB during the 1990s. Evaluate the proposal to expense ESOs in relation to the four criteria presented in Section 13.5 of the course textbook. (Four criteria - decision usefulness, reduction of information asymmetry, economic consequences of new standards and consensus)