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In March 2003, the Financial Accounting Standards Board (FASB) began reconsidering the accounting standard for equity-based compensation. The accounting board released an exposure draft for a revised standard on March 31, 2004. That revised standard would require firms to recognize the fair value of employee stock options as an expense, as was first proposed by FASB more than 10 years ago.

This Congressional Budget Office (CBO) paper assesses whether, under the current accounting standard, firms that grant employee stock options without recognizing an expense overstate their reported income. The paper presents the relevant issues, describes the current standard for employee stock options, compares the intrinsic value and fair value methods of measurement, and weighs the potential economic effects of revising the current standard. The report was prepared at the request of Congressman Brad Sherman in his capacity as a member of the House Committee on Financial Services.

Judith S. Ruud of CBO's Microeconomic and Financial Studies Division prepared the paper under the direction of Roger Hitchner and Marvin Phaup. Early investigation of the subject was conducted by Douglas Gruener, a summer intern at CBO. George J. Benston of Emory University and Deborah Lucas of Northwestern University reviewed a draft of the paper and provided valuable suggestions. Wendy Kiska, Angelo Mascaro, David Torregrosa, Philip Webre, and Thomas Woodward, all of CBO, also provided helpful comments.

Christine Bogusz and Leah Mazade edited the paper, and John Skeen proofread it. Maureen Costantino prepared the paper for publication and designed the cover, and Annette Kalicki produced the electronic versions for CBO's Web site.

Douglas Holtz-Eakin
Director
April 2004