What's Wrong with Expensing Employee Stock Options?

The Federal Accounting Standards Board (FASB) has concluded that employee stock options (ESOs) should be expensed by firms that issue options to their employees, and without further action by the SEC or Congress, ESOs will be expensed beginning next year. The debate over the expensing of employee stock options (ESOs) has been intense in recent years. The two central question of this debate--namely, whether employee stock options should be expensed in the issuing firm?s GAAP accounts, and if so, which quantitative model should be used for that purpose--remain hotly contested. In this essay, I show (in Sections 2-6) that advocates of expensing make a variety of conceptual errors about the incidence of costs associated with the granting of employee stock options. When the arguments for expensing are considered carefully, it is clear that there is no legitimate basis for the proposed expensing of employee stock options. In Sections 7-10, I also examine the problems of measurement of the costs associated with employee stock options, which have been severely underestimated by proponents of expensing. Section 11 concludes with an alternative proposal for achieving the legitimate disclosure objectives of the advocates of expensing, while avoiding the errors and distortions that the expensing of ESOs would create.