Employee Stock Option Fair-value Estimates: Do Managerial Discretion and Incentives Explain Accuracy?

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Abstract
We examine the determinants of managers' use of discretion over employee stock option (ESO) valuation-model inputs that determine ESO fair values. We also explore the consequences of such discretion. Firms exercise considerable discretion over all model inputs and this discretion results in material differences in ESO fair-value estimates. Contrary to conventional wisdom, we find that a large proportion of firms exercise value-increasing discretion. Importantly, we find that the use of discretion improves predictive accuracy for about half of our sample firms. Moreover, we find that both opportunistic and informational managerial incentives together explain the accuracy firms' ESO fair value estimates. Partitioning on direction of discretion improves our understanding of managerial incentives. Our analysis identifies that financial statement readers can use mandated contextual disclosures to construct powerful ex ante predictions of ex post accuracy.