The revision of SFAS No. 123 (SFAS No. 123R, FASB 2004) requires companies to recognize the fair value of employee stock options. In addition, nonpublic companies will no longer be permitted to assume stock price volatility of zero when calculating the fair value of their stock options. This study finds that the zero volatility assumption allowed under the original version of SFAS No. 123 (FASB 1995) resulted in an average estimated fair value of options that was $1.06 (40 percent) less than the fair value calculated using a peer group volatility estimate for firms undergoing an initial public offering (IPO). However, IPO firms that estimated their volatility underreported option values by an even larger magnitude than the group using the zero volatility assumption. Perhaps these firms reported a downward‐biased estimate of volatility to inhibit analysts from computing option values using more reasonable volatility estimates.

Contrary to the findings for public companies, we find that a large percentage of sample firms issued in‐the‐money options prior to going public. Following the IPO, only a small portion of firms issued in‐the‐money options. The concerns regarding recognizing option expense may be less important than the benefits of granting in‐the‐money options for IPO firms.

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