In 1993, the Financial Accounting Standards Board (FASB) in the United States issued a controversial exposure draft of a proposed new accounting standard on executive stock options (ESOs). The exposure draft proposed that firms record compensation expense based on the fair value of ESOs issued in the period. The fair value is to be estimated as of the grant date.

There was significant opposition to this exposure draft from several business groups, and it also faced opposition in the U.S. Congress. Opponents of this standard argued that the adoption of such a standard would have adverse consequences on the U.S. economy. Faced with stiff opposition, the FASB dropped the exposure draft. Instead, FASB issued SFAS No. 123 which allowed firms to use either the intrinsic value or the fair value of the ESO on the grant date in the financial statements, as long as the firms disclosed the fair value of ESOs issued in the footnotes to the financial statements.

Required: a. One of the concerns of the opponents of this proposed new standard is that the adoption of this standard will lead to a loss of employee motivation. Discuss the basis of this concern. b. One of the arguments of the opponents of this proposed new standard is that there is no cash outlay for the ESOs, and, thus, it should not be treated as an expense. In fact, the firm receives cash when holders of ESOs exercise their options. Indicate whether or not you agree that there are no costs associated with issuing ESOs. Discuss. c. A number of academic articles pointed out that use of the Black/Scholes formula leads to a loss of reliability of the calculated expense of ESOs. Discuss one reason why the application of the Black/Scholes formula may give rise to error in the estimated fair value of ESOs.