QUESTION:

Expensing of employee stock options (ESOs) is now a requirement in financial reporting both under U.S. GAAP and IFRS. However, management, especially in the United States, successfully resisted expensing for many years before the expensing rules were finally adopted. Even now, accounting for ESOs remain a controversial topic.

Required

a. Evaluate the relevance and reliability of ESO expenses when calculated using the Black/Scholes formula or a similar model.

b. Researchers have observed that managers compensated by ESOs tend to release bad news prior to ESO grant dates and good news prior to ESO exercise dates. Discuss the incentives of managers to choose this timing for release of bad and good news.

c. One noteworthy feature about the fair value of an ESO is that its lowest value is zero when the price of the underlying stock is less than the exercise price. On the other hand, the value of an ESO can be very high when the price of the underlying stock is significantly higher than the exercise price.

d) Discuss the effect of this asymmetric feature of ESOs on managers incentive to undertake risky projects. In other words, do these features lead to managers undertaking high-risk projects or low-risk projects?