A dissertation submitted to the faculty of the University of Mississippi in partial fulfillment of the requirements of the Sally McDonnell Barksdale Honors College. First and foremost, I would like to thank my thesis supervisor, Dr. Elam, for his help and dedication to this project over the past year. I would also like to thank all my friends and family who encouraged me during my graduate work.
I wouldn't have finished my thesis without late nights at Tri-Delta, writing and stealing cookie dough from the kitchen. Sally McDonnell Barksdale Honors College has played a huge role in the person I have become and my time at this university. Finally, the honors college has provided me with rich learning experiences inside and outside the classroom.
Previous research in stock option accounting has found that option valuations and subsequent accounting practices are misrepresented to help a company appear financially stronger. This is important because FASB Standard 123(R) (2004) and the Sarbanes-Oxley Act (2000) have both been put into practice since most of the data was analyzed.
INTRODUCTION
High capital compensation should be fairly reflected in the company's income statement and balance sheets. The hypothesis could be confirmed by a significant increase in stock-based compensation expense in the years following the initial public offering. Jive Software, LinkedIn, and Zillow all had initial public offerings in 2011, and all three companies are in the technology industry.
Before the analysis of three sets of accounts, relevant standards and accounting protocol are explained. Also, previous research in the field related to this study is included to better understand the work already completed.
STANDARDS FOR STOCK OPTIONS
Because of this inability, options are sometimes exercised early, changing the general expected period of the ESO. Compensation expense under the fair value method is measured on the grant date based on the value of the award and recognized over the service period. For example, ABC Company creates a stock compensation plan that gives an employee the option to acquire 1,000 shares of the company's common stock at $8 per share.
The fair market value of the stock is currently $10 per share and the fair market value of the option is $5 per option. After the vesting period, the employee is ready to purchase the stock at the option contract price when the fair market value of the stock has increased to $12 per share. The previous example shows that the FMV of the options is not present and the fair market value of the shares at the time of vesting is $12 and the contract allows the employee to purchase the shares for $10 per share.
NAT Company recognizes the value of the options as an expense in the periods in which the beneficiary employees perform services. Regarding the balance sheet presentation of stock options, the options can be classified as a liability or as equity based on the terms of the options.
PREVIOUS RESEARCH
The research by Aharony, Lin and Loeb provides a broad overview of the possibilities for earnings management by a company before an IPO. Their research concluded that companies using historical volatility estimates underestimated the fair value of the options as much as companies using zero volatility. This study was conducted in the wake of the publication of FASB Standard 123(R) and aimed to find empirical evidence to support their claim about the relationship between equity incentives and earnings management.
Accounting Standard 123 (R) requires fair market value reporting of stock options instead of the disclosure in the footnotes that was previously required. -Oxley is also significant because it causes accounting regulations for public companies to be much stricter. 2014) mentioned in the study's conclusion that further research needs to be completed to determine whether discretion in stock option reporting exists in the post-Sarbanes-Oxley era. IPO firms can "exercise discretion" over both intrinsic value and time value of the stock options.
The intrinsic value of a stock option is the difference between the exercise price of the option and the market price of the underlying stock. The time value of a stock's price is based on the stock's volatility and the life of the option contract, both of which leave a lot of room for judgment, especially for private companies. Not only must companies recognize the fair value of options, but they must no longer use zero volatility.
By eliminating zero-volatility estimates, all companies must look to the historical volatility of peer industry groups. The time value of options is related to the future price of the stock underlying the stock options to change before expiration. Therefore, management determines volatility. consequently, it causes discretion in the time value of options.
This idea explains incentive compensation because options are based on future stock values. By another assumption, tech startups that compensate heavily with stock options would tend to use discretion in reporting volatility and not as much discretion in stock value on the grant date. Regarding the variables in the pricing model, they found that volatility and life expectancy had the strongest influence on cost underestimation.
SELECTED COMPANY EXAMPLES
The footnotes help explain the figures on the front of the financial statements. Jive based their estimates on calculated volatilities based on the “historical closing prices of common stocks of comparable entities whose stock prices are available for the expected life of the option.” The following graph shows the volatility for each of the five years in the sample period. The final variable that affects the value of Jive's options is the expected term of the options.
The credit of the following journal entries has been verified by reference to the statement of stockholders' equity. For each year, the statement of stockholders' equity has a line that reads “Share-based compensation,” and the amount of compensation expense is indicated under the additional paid-in capital column and the total stockholders' equity column. For Jive Software, all compensation expense shown in Note 10 to the financial statements matched the amount of stock-based compensation shown in the statement of stockholders' equity.
The cash portion of the entry is found in the Statement of Cash Flows under financing activities. However, in 2011, the year of the IPO of stock-based compensation expense was included in the consolidated statement of operations. LinkedIn allocates employee stock option expenses to the various cost centers based on the position of the employee.
Upon further investigation of the notes to the financial statements, there is nothing to indicate this discrepancy in the entries. Excluding the missing debit entry, total stock-based compensation expense nearly triples in the year of the offering. Stock option exercise is another important part of stock option accounting.
The cash portion comes from the Statement of Cash Flows under the financing section on the line "proceeds from the issuance of common stock." To. With the IPO in 2011, Zillow created a new stock-based compensation plan entitled the "2011 Plan" that replaced the "2005 Plan." The 2011 Plan allows Zillow to grant stock-based compensation to employees, officers, directors, consultants, agents, advisors and independent contractors. All of these options are considered non-qualified stock options and the maximum term of the options is ten years.
Therefore, this is not a cause of the discrepancy in the additional paid-in capital related to options and compensation costs. However, like Jive and LinkedIn, Zillow is an example of a significant increase in equity compensation costs in the year of its public offering and beyond.
CONCLUSION
Previous research in this area leads to the hypothesis that firms have an incentive and opportunity to misvalue options, but without information that is confidential to individual firms, the hypothesis is difficult to definitively prove or disprove. After a thorough analysis of the financial statements of Jive, LinkedIn and Zillow and the notes to the consolidated financial statements, more research is required. Previous research in this area had not been conducted in accordance with the change in standards, so it was worth considering how the new standards changed the way stock option research was conducted.
More advanced statistical models and information from the companies that are not made public could be important to draw conclusions about this hypothesis. This graph shows all three start-up companies on one plane, illustrating the change in option costs from two years before the public offering in 2009 to two years after the public offering in 2013. The vertical line in the graph marks 2011 and indicates that the left half of the graph shows the cost amounts before the IPO, while the right half shows the cost amounts after the IPO.
As can be seen from the graph, the trend among all three companies is the same, around the amount of the initial public offering costs. This is a sign that cost manipulation could be present among companies undergoing initial public offerings.
