The Theory

The method of calculation was not to be mandated. This Model was developed in and consists of a set of algebraic equations. It has been used by many option traders. In essence, FASB was saying that, if the company sold the option in the public market, it would receive a cash payment from the buyer. By giving the option to the employee, the company was foregoing the cash it would receive if it sold the option. Subsequent to the floating of the draft proposal by FASB in , many hi-tech companies voiced strong objection.

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These companies argued that employee stock options were the primary incentive they had to recruit technology professionals and to motivate various levels of employees. The opposition by technology companies did not immediately influence FASB, and the development of a proposed standard requiring expensing continued. At that point hi-tech companies began contacting their Congressional representatives. When FASB failed to bend, members of Congress took an extremely aggressive posture on this matter — to the point that the existence of FASB as an independent standard setter was threatened.

In repose to this threat, FASB Statement was revised to require only footnote disclosure of the pro forma effect on net income and earnings per share if an expense had been recorded.

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The concept of a level playing field has been supplemented with a new rationale for recording the expense. This rationale starts with the premise that companies such as Enron, Global Crossing, and WorldCom used accounting treatments that were improper and unethical in order to inflate net income and earnings per share. These company executives were motivated to increase the stock price because it would be financially rewarding to the management since they held substantial options on the stock.

  • central option trading.
  • Stock option expensing?
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  • Consider the Pros and Cons of Expensing Stock Options.
  • Expensing Stock Options: A Fair-Value Approach.
  • Understanding Your Employee Stock Options.
  • If the companies had been required to record an expense at the time the option was granted, they would not have been so generous with the options. By curtailing the options, the incentive to inflate net income and earning per share would have been reduced. Several arguments have been made, both pro and con, regarding this issue. Following is a summary of the key arguments on both sides. At the time the option is exercised, the employee must pay for the shares received.

    As to the improved corporate governance argument for the change, the Securities and Exchange Commission certainly has just cause to seek improvements in corporate governance. However, there are ways of accomplishing this without creating controversial accounting requirements and penalizing employees below the top level of management.

    Expensing Stock Options: A Fair-Value Approach

    There are more effective ways to accomplish this than the FASB proposal on expensing options. For additional views on the subject of expensing stock options, please refer to the following Wall Street Journal articles:. Web services will enable organizations to integrate their information, applications, workflows, and customer transactions in more versatile web environments. No longer does one plus one always equal two — in a given reporting period anyway.

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      This article summarizes how prescriptive analytics techniques are used in practice by retirees to maximize retirement portfolio longevity. There are two issues surrounding the recording of an expense when an option is awarded: Does the expensing provide a level playing field in accounting for management compensation? Indeed, by more than 90 percent of stock options were being granted to managers and employees.

      The Practice

      Hall and Murphy argue that, in many cases, stock options are an inefficient means of attracting, retaining, and motivating a company's executives and employees since the company cost of stock options is often higher than the value that risk-averse and undiversified workers place on their options. In regard to the first of these aims - attraction -- Hall and Murphy note that companies paying options in lieu of cash effectively are borrowing from employees, receiving their services today in return for payouts in the future.

      But risk-averse undiversified employees are not likely to be efficient sources of capital, especially compared to banks, private equity funds, venture capitalists, and other investors. By the same token, paying options in lieu of cash compensation affects the type of employees the company will attract.

      The Cost of Share Dilution

      Options may well draw highly motivated and entrepreneurial types, but this can benefit a company's stock value only if those employees- that is, top executives and other key figures -- are in positions to boost the stock. The vast majority of lower-level employees being offered options can have only a minor affect on the stock price. Options clearly promote retention of employees, but Hall and Murphy suspect that other means of promoting employee loyalty may well be more efficient.

      Pensions, graduated pay raises, and bonuses - especially if they are not linked to stock value, as options are - are likely to promote employee retention just as well if not better, and at a more attractive cost to the company. In addition, as numerous recent corporate scandals have shown, compensating top executives via stock options may inspire the temptation to inflate or otherwise artificially manipulate the value of stock. Hall and Murphy maintain that companies nevertheless continue to see stock options as inexpensive to grant because there is no accounting cost and no cash outlay.

      Furthermore, when the option is exercised, companies often issue new shares to the executives and receive a tax deduction for the spread between the stock price and the exercise price.

      How Do Employee Stock Options Work?

      These practices make the "perceived cost" of an option much lower than the actual economic cost. But such a perception, Hall and Murphy maintain, results in too many options for too many people. From the perceived cost standpoint, options may seem an almost cost-free way to attract, retain, and motivate employees, but from the standpoint of economic cost, options may well be inefficient. Hall and Murphy's analysis has important implications for the current debate about how options are expensed, a debate that has become more heated following the accounting scandals.

      A year ago the Financial Accounting Standards Board FASB announced that it would consider mandating an accounting expense for options, with hopes that this would be adopted early in Federal Reserve Chairman Alan Greenspan, investors like Warren Buffet, and numerous economists endorse recording options as an expense.

      The Benefits And Value Of Stock Options

      Chamber of Commerce, and high-tech associations oppose "expensing" options. The Bush Administration sides with these opponents, while Congress is divided on the issue. Hall and Murphy believe that the economic case for "expensing" options is strong.