Abstract
In the wake of the recent corporate scandals that have damaged investor confidence, policymakers, academics, and pundits have taken aim at accounting rules as one of the areas in need of reform. Proposals for changing the rules governing the accounting for the granting of stock options has become one of the most hotly contested areas. Advocates of reform argue that options are a form of compensation and that granting options entails real costs to stockholders. They argue that it follows that options should be included as an expense item in the firm's financial statements.
In this article, we consider the potential benefits and costs of requiring the expensing options. First, we show that the potential benefits of developing rules for expensing options would be small, even if the valuation of the options were straightforward. Second, we review practical problems that make it extremely difficult to create a set of accounting conventions that would properly value the options. We conclude that the establishment of new accounting rules for expensing options would likely do more harm than good.