New FASB rule on expensing employee stock options will reduce reported income of firms

May 4, 2004 -- The recently proposed rule by the Financial Accounting Standards Board (FASB) that requires companies to treat employee stock-option compensation as an expense on corporate income statements will reduce the reported income of firms, according to Todd Milbourn, a professor of finance at the Olin School of Business at Washington University in St. Louis. The new rule, if finalized after a 90-day comment period, will go into effect next year.

The proposed rule by the FASB is expected to significantly influence investor behavior. But Milbourn said that the ultimate effect of the proposed rule is somewhat uncertain. "Firms have already had to disclose to investors the amount and terms of employee stock options grants," he said, "so investors should already be aware of the level of a firm's options grants."

Todd Milbourn

But research by Milbourn shows that investors have often been surprised at the dilution they face when employees exercise options grants, even though they were previously disclosed (see "Do Stock Prices Incorporate the Potential Dilution of Employee Stock Options?").

Milbourn said that while the cost of employee stock options has always been a key, if not major component of a firm's total labor costs, the costs directly associated with options compensation will be more transparent now. "To the extent that investors aren't fully internalizing the labor costs associated with option grants as they are currently reported, such an obvious disclosure and recognition of this labor cost in the firm's earnings releases should make investors more informed."

The new FASB rule will essentially add yet another variant of Net Income to corporate financial statements, Milbourn said.

Many analysts have predicted that the new FASB rule may also impact innovation and growth within firms that rely heavily on options to attract top talent, particularly technology-driven companies. "Firms with greater growth potential tend to be the biggest users of employee stock options as a means of motivating and retaining key employees," Milbourn said.

"If these firms fear that further reductions to their reported net income may cause some unease among investors, they may scale back their use. This would be unfortunate. However, in an efficient financial market, investors should not be wary of stock options when they are employed wisely, and the better firms will recognize this and continue to use them accordingly.

"Given that the vast majority of firms grant stock options to their employees, the proposed FASB rule will clearly reduce the reported income of the average firm," Milbourn said.