Positive accounting theory and employee stock option pricing decisions

¶ … employee stock option pricing is effected by the bonus plan hypotheses as discussed in the Watts and Zimmerman article.

Employee stock option pricing is an option on the common stock of a company that is issued as a form of non-cash compensation. Restrictions on the option (as for instance vesting and limited transferability) are ways in which the business attempts to align its own interests with those of the holder's interests. In the event of the company's stock rising, holders of options generally experience a direct financial benefit, which gives employees the incentive to behave in ways that will boost the company's stock price (Summa; web).

The management compensation hypothesis, otherwise known as the Bonus plan hypothesis accordingly states that managers whose incentives are tied up with the firm's accounting performance are more likely to use accounting choices that reduce reported profits and manipulate their accounting methods and records in particular ways in order to show more profits and efficiency than would otherwise be the case. An example that Watts and Zimmerman provide is that of managers choosing to use different deprecation methods that show lower profits at the start and higher profits towards the end. Similarly, some managers may ignore research and development costs since it will lower their current year profits that will, in turn, affect their income.

Watts and Zimmerman talk about positive accounting theory that is the model where empirical finance methods were used for financial accounting. Modern positive accounting gave rise to explanatory factors for various phenomena, one of which can be applied to explaining how employee stock option pricing is effected by the bonus plan hypothesis.

By using an empirical account, positive accounting theory focuses on the contractual view of the firm. The firm is perceived as the 'nexus of contracts' and the company uses accounting as one tool to facilitate its performance of contracts for the greater advantage of its firm. As Watts and Zimmerman therefore explain how firms may adopt income-decreasing accounting methods so as to deal with contractual situations -- such as employee stock option pricing, and incentive (such as bonus plans) are created to manage reported numbers. What this does is that it helps to mitigate contracting costs by arranging ex-ante agreements amongst the varying parties of buyer and seller. In this case, we see how the company by focusing on its financial contract between the two parties, the buyer and the seller acts in such a way that it brings compensation and reward to itself since the buyer of the call option wants the price of the negotiation (or the consequence of his profits) to rise in the future