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.
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. What artistry. Introduction Value for Money VfM analysis helps governments decide whether it is more cost-effective to do a project through traditional procurement, or through PPPs.
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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?
Would the recording of an expense when an option is awarded improve corporate governance? Pros Expensing options will provide a level playing field so that companies that use cash bonuses and companies that use stock options each have an expense on the income statement. It will improve corporate governance by reducing or eliminating incentives to inflate income and earnings per share.
Cons The playing field is already level. A company using cash bonuses as management incentive compensation has a reduction in net income and a resultant reduction in earnings per share. When a stock option has been awarded and the strike price is in the money, the additional shares become outstanding for purposes of calculating earnings per share.
Since earnings per share is calculated by dividing net income by weighted average shares outstanding, as the shares outstanding increase, the earnings per share decrease. To require a company to record an expense for the option, and subsequently increase the shares outstanding is a double hit to earnings per share. Regarding improved corporate governance, it is difficult to believe that the management or the Board of Directors of Enron would have limited the number of options simply because of the requirement to record an expense.
Such is the nature of recording an expense when an option is awarded. This is an accounting entry with no cash impact. This would likely lead to companies including a pro forma income statement which excluded the option expense. Hi-tech companies have traditionally issued options to multiple levels of employees with two purposes in mind: attract high quality employees to the company; and motivate workers at all levels. If hi-tech companies were required to record an expense at the time options are granted, many employees at all levels would most likely lose the options.
For the Last Time: Stock Options Are an Expense
This stock must be held for two years before it can be sold. Bartley, July 29, Back to top. Share Facebook. But deferring recognition of stock option expense flies in the face of both accounting principles and economic reality. Expenses should be matched with the revenues associated with them.
The cost of an option grant should be expensed over the time, typically the vesting period, when the motivated and retained employee is presumed to be earning the grant by generating additional revenues for the company. Some degree of measurement error is no reason to defer recognition; accounting statements are filled with estimates about future events—about warranty expenses, loan loss reserves, future pension and postemployment benefits, and contingent liabilities for environmental damage and product defects.
The final defense of the antiexpensing lobby is its claim that other financial-statement estimates based on future events are eventually reconciled to the settlement value of the items in question.
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For instance, estimated costs for pension and postretirement benefits and for environmental and product-safety liabilities are ultimately paid in cash. At that time, the income statement is adjusted to recognize any difference between actual and estimated cost. As the opponents of expensing point out, no such correcting mechanism currently exists to adjust grant-date estimates of stock option costs.
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A procedure that we call fair-value expensing for stock options eliminates forecasting and measurement errors over time. A procedure that we call fair-value expensing adjusts and eventually reconciles cost estimates made at grant date to subsequent actual experience in a way that eliminates forecasting and measurement errors over time. Our proposed method involves creating entries on both the asset and equity sides of the balance sheet for each option grant.
This accounting mirrors what companies would do if they were to issue conventional options and sell them into the market in that case, the corresponding asset would be the cash proceeds instead of prepaid compensation. The prepaid-compensation account is then expensed through the income statement following a regular straight-line amortization schedule over the vesting period—the time during which the employees are earning their equity-based compensation and, presumably, producing benefits for the corporation.
Stock option expensing - Wikipedia
At the same time that the prepaid-compensation account is expensed, the stock option account is adjusted on the balance sheet to reflect changes in the estimated fair value of the granted options. The company obtains the periodic revaluation of its options grant just as it did the grant-date estimate, either from a stock options valuation model or an investment-bank quote.
The amortization of prepaid compensation is added to the change in the value of the option grant to provide the total reported expense of the options grant for the year. At the end of the vesting period, the company uses the fair value of the vested stock option—which now equals the realized compensation cost of the grant—to make a final adjustment on the income statement to reconcile any difference between that fair value and the total of the amounts already reported in the manner described. The options can now be quite accurately valued, as there are no longer any restrictions on them.
Market quotes would be based on widely accepted valuation models.
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In this case, the cost to the company will be less than if the employee had retained the options because the employee has forgone the valuable opportunity to see the evolution of stock prices before putting money at risk. The approach we have described is not the only way to implement fair-value expensing. Companies may choose to adjust the prepaid-compensation account to fair value instead of the paid-in capital option account. In this case, the quarterly or annual changes in option value would be amortized over the remaining life of the options.
This would reduce the periodic fluctuations in option expense but involve a slightly more complex set of calculations. The great advantage of fair-value expensing is that it captures the chief characteristic of stock option compensation—namely that employees are receiving part of their compensation in the form of a contingent claim on the value they are helping to produce.
The Theory
Fair-value expensing captures the chief characteristic of stock option compensation—that employees receive part of their pay in the form of a contingent claim on value they are helping to produce. If the market is actually trading options with exactly the same exercise price and maturity as the vested stock options, Kalepu can use the quoted price for those options instead of the model on which that quoted price would be based. What happens if an employee holding the grant decides to leave the company before vesting, thereby forfeiting the unvested options?