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.
