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We investigate whether footnote disclosures under Statement of Financial Accounting Standards (SFAS) No. 123 are managed in 1996, the first year that the disclosure was required. The 1996 phase-in of SFAS No. 123 provided firms with a unique opportunity to manipulate the pro forma disclosure in the initial years. SFAS No. 123 allows firms discretion in estimating the value of their stock option grants and in allocating that value across accounting periods. Although we find little evidence that firms manage the estimated value of their option grants, we find that firm-specific incentives affect how that value is allocated. Specifically, firms that provide high levels of either CEO compensation or stock option compensation relative to performance allocate a smaller proportion of the options' value to the 1996 pro forma expense, apparently to reduce criticism of that compensation. Small firms and firms that recently went public also allocate a smaller proportion of option value to the 1996 pro forma expense, apparently to increase perceptions of their profitability. We conjecture that firms were less likely to manage the value of the options granted than the allocation of that value in 1996 because the parameter estimates underlying the reported option value must be disclosed in the footnote, whereas the inputs to the allocation computation are not disclosed. These results, which suggest that firms manipulated pro forma stock option expense when their estimate choices cannot be observed, have implications for both standard setters and financial statement users. In particular, the FASB's current deliberations on the transition from footnote disclosure to income statement recognition for stock options should consider additional disclosures to minimize unobservable choices. More generally, the FASB may reduce potential manipulation by requiring expanded disclosures about the choices used in computing both pro forma and reported numbers.

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This article provides a detailed analysis of accounting for employee Stock Options (ESOs) in the U.S. to illustrate the limitations in conceptual frameworks of accounting that follow the FASB's model. While the FASB's Conceptual Framework of Accounting addresses measurement issues (e.g., historical cost versus current cost), asset definition issues (e.g., how to classify bond discounts) and liability and timing issues (e.g., how to treat executory contracts), it does not provide an accounting model or 'view' for a number of economic events. In cases where an alternative view exists and the conceptual framework has different timing and measurement implications for each of the views, the FASB's conceptual framework cannot be used to obtain regulators' political support for standard-setters' recommendations. Hence, there are a number of troublesome accounting issues, such as ESOs, for which the FASB risks ceding control of the standard-setting process to the SEC. A better model for conceptual frameworks might be one that contains specific definitions of economic events in terms of accounting elements and an explicit statement whether the attributes of relevance or reliability are of paramount concern.

This article provides a residual-income valuation framework for assessing whether fair value disclosures required by SFAS 119, Disclosures About Derivative Financial Instruments and Fair Values of Financial Instruments, are value-relevant. The primary theoretical and empirical result is that when using a residual-income valuation model, the estimated relation between variables measuring fair value-book value differences for financial instruments and security prices may be contrary to what one would have expected. Specifically, the greater the firm's return on invested capital and growth rate relative to its cost of capital, the more negative the estimated relation between fair value-book value differences for financial instruments and security prices. A generalization of this result is that tests linking equity values to various types of unrecognized gains and losses are, in many cases, unlikely to generate the hypothesized positive relation between equity values and the unrecognized gains and losses.