Barth, Hodder, and Stubben examine how the risk and expected return of existing shares varies as a function of the amount of outstanding employee stock options (ESOs), finding that the association is a negative one, consistent with ESOs being equity-like in character. They suggest that their approach could be used to address the question of how best to characterize other complex financial claims. The study is well executed and provides a thought-provoking contribution to the debate. However, it is far from obvious that the ‘‘debt or
equity’’ question can be solved in this manner. Their approach effectively defines a liability as a financial claim that has characteristics akin to fixed-rate debt. I provide examples of the limitations of this perspective, starting by comparing ESOs that are settled with shares with those settled in cash. Whether a claim is treated as a liability or equity is of little con- sequence if it is simply a matter of balance sheet presentation. The real question is the implications for income measurement. I suggest progress might best be made if we start with Penman’s proposal that assets and liabilities be separated into oper- ating and financial items, an approach which would include many claims that have equity-like characteristics, such as unvested ESOs, within the operating liability category. Once a claim ceases to be an operating item—e.g. when an ESO vests—the approach suggested in the paper can then be used to determine how it should be
classified.