SFAS 123 Stock-Based Compensation Expense and Equity Market Values

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Abstract
The objective of this study is to understand the relation between equity market values and stock-based employee compensation expense that is disclosed, but not recognized in determining net income, under Statement of Financial Accounting Standards (SFAS) No. 123. In particular, we predict and find that stock-based compensation expense has a negative relation with share price, consistent with investors viewing it an expense of the firm. This finding calls into question the quality of reported earnings, because without recognition of stock-based compensation expense under SFAS 123, this expense is never included in the net income. It also indicates that stock-based compensation expense is measured with sufficient reliability to be reflected in investor's valuation assessments. Our tests focus on the relation between share price and stock-based compensation expense, after controlling for net income, book value of equity, and expected future earnings growth. Our findings are consistent with our predictions, indicating that investors view stock-based compensation expense as an expense of the firm, after controlling for reported net income, book value of equity, and expected future earnings growth.