An employee stock option is a type of call option granted by a business to an employee giving them the right to buy stock in the business at an agreed price on or before a specific date. The price is usually lower than the market price and is treated as part of the compensation of the employee. When dealing with stock option compensation accounting there are three important dates to consider. The granting of stock options is a form of compensation given to key personnel employees, advisers, other team members etc.
Like any other form of compensation, such as the cash payment of wages and salaries or fees to advisers, it is a cost to the business. Like any cost, the cost of compensating the key personnel for their services if the fair value of the service they provide. If for example an employee is paid a salary then the amount paid is regarded as a reflection of the fair value of the service provided.
Likewise for stock option based compensation the fair value of the options granted can be used as an indication of the fair value of the service provided and therefore the cost to the business. The vesting period is important in stock option compensation accounting as it sets the time period over which the cost of compensating the option holder is treated as an expense in the income statement. The purposes of granting stock options is to enable a business, particularly a startup business, to recruit, reward, and retain key personnel.
To ensure a employee does not immediately exercise their newly granted options and leave the business before the task they were employed for is complete, it is normal to have a vesting period. The vesting period is the period of time between the grant date and the vesting date at which the option holder receives the rights to exercise the option and purchase shares in the business. This is shown in the diagram above. So for example an employee might be granted 20, options but only receives the right to exercise then over a 4 year period at the rate of 5, options each year.
In addition a business will often have a requirement that if an employee leaves within a certain time period, for example one year, then they forfeit the right to excise any options and therefore leave without any shares in the business. The date before which the employee loses all rights to exercise the options is referred to a cliff.
At the start of the year a business grants five key personnel stock options each. The fair value FV of each option at the date of grant is 7. The options vest at the end of a 3 year period at which point the option holders can exercise their options.
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The exercise strike price is the same as the share price at the date of grant which is During the vesting period the business needs to expense the total stock option compensation cost of the employees providing the service. The total cost is the fair value of the service which is represented by the fair value of the options granted in return for the service. In this example the cost is 7.
The total expected stock option compensation cost over the 3 year vesting period is calculated as follows. Since the vesting period is three years and one year of the service period has now been completed the business calculates the stock option compensation expense for the year as follows. The stock option expense for year 1 3, is the difference between the cumulative expense at the end of year 1 3, and the cumulative expense previously recognized 0.
The stock option compensation is an expense of the business and is represented by the debit to the expense account in the income statement. The other side of the entry is to the additional paid in capital account APIC which is part of the total equity of the business. Since two years of the service period have now been completed the business calculates the stock option compensation expense for the year as follows. The stock option expense for year 2 2, is the difference between the cumulative expense at the end of year 2 5, and the cumulative expense previously recognized in year 1 3, Since three years of the service period have now been completed the business calculates the stock option compensation expense for the year as follows.
The stock option expense for year 3 is the difference between the cumulative expense at the end of year 3 6, and the cumulative expense previously recognized in year 2 5, We then discuss just how firms might go about reporting the cost of options on their income statements and balance sheets.
For the Last Time: Stock Options Are an Expense
It is a basic principle of accounting that financial statements should record economically significant transactions. For many people, though, company stock option grants are a different story.
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These transactions are not economically significant, the argument goes, because no cash changes hands. That position defies economic logic, not to mention common sense, in several respects. For a start, transfers of value do not have to involve transfers of cash. While a transaction involving a cash receipt or payment is sufficient to generate a recordable transaction, it is not necessary.
Events such as exchanging stock for assets, signing a lease, providing future pension or vacation benefits for current-period employment, or acquiring materials on credit all trigger accounting transactions because they involve transfers of value, even though no cash changes hands at the time the transaction occurs.
Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost, which needs to be accounted for. It is exactly the same with stock options. When a company grants options to employees, it forgoes the opportunity to receive cash from underwriters who could take these same options and sell them in a competitive options market to investors.
It can, of course, be more reasonably argued that the cash forgone by issuing options to employees, rather than selling them to investors, is offset by the cash the company conserves by paying its employees less cash. As two widely respected economists, Burton G. Malkiel and William J. Instead, it can offer stock options. The following hypothetical illustration shows how that can happen. Imagine two companies, KapCorp and MerBod, competing in exactly the same line of business.
The two differ only in the structure of their employee compensation packages. Economically, the two positions are identical. How legitimate is an accounting standard that allows two economically identical transactions to produce radically different numbers? MerBod will also seem to have a lower equity base than KapCorp, even though the increase in the number of shares outstanding will eventually be the same for both companies if all the options are exercised.
This distortion is, of course, repeated every year that the two firms choose the different forms of compensation. Some opponents of option expensing defend their position on practical, not conceptual, grounds. Option-pricing models may work, they say, as a guide for valuing publicly traded options. And for stock options, the absence of a liquid market has little effect on their value to the holder. The great beauty of option-pricing models is that they are based on the characteristics of the underlying stock.
The Black-Scholes price of an option equals the value of a portfolio of stock and cash that is managed dynamically to replicate the payoffs to that option. And that applies even if there were no market for trading the option directly. Investment banks, commercial banks, and insurance companies have now gone far beyond the basic, year-old Black-Scholes model to develop approaches to pricing all sorts of options: Standard ones. Exotic ones. Options traded through intermediaries, over the counter, and on exchanges.
Options linked to currency fluctuations. Options embedded in complex securities such as convertible debt, preferred stock, or callable debt like mortgages with prepay features or interest rate caps and floors. A whole subindustry has developed to help individuals, companies, and money market managers buy and sell these complex securities. Current financial technology certainly permits firms to incorporate all the features of employee stock options into a pricing model. But financial statements should strive to be approximately right in reflecting economic reality rather than precisely wrong.
Managers routinely rely on estimates for important cost items, such as the depreciation of plant and equipment and provisions against contingent liabilities, such as future environmental cleanups and settlements from product liability suits and other litigation. Not all the objections to using Black-Scholes and other option valuation models are based on difficulties in estimating the cost of options granted. Since almost all individuals are risk averse, we can expect employees to place substantially less value on their stock option package than other, better-diversified, investors would.
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The existence of this deadweight cost is sometimes used to justify the apparently huge scale of option-based remuneration handed out to top executives. We would point out that this reasoning validates our earlier point that options are a substitute for cash. Financial statements reflect the economic perspective of the company, not the entities including employees with which it transacts. When a company sells a product to a customer, for example, it does not have to verify what the product is worth to that individual.
It counts the expected cash payment in the transaction as its revenue. The company records the purchase price as the cash or cash equivalent it sacrificed to acquire the good or service. Suppose a clothing manufacturer were to build a fitness center for its employees. The company would not do so to compete with fitness clubs. It would build the center to generate higher revenues from increased productivity and creativity of healthier, happier employees and to reduce costs arising from employee turnover and illness.
The cost to the company is clearly the cost of building and maintaining the facility, not the value that the individual employees might place on it. The cost of the fitness center is recorded as a periodic expense, loosely matched to the expected revenue increase and reductions in employee-related costs.
Fallacy 1: Stock Options Do Not Represent a Real Cost
While we agree with the basic logic of this argument, the impact of forfeiture and early exercise on theoretical values may be grossly exaggerated. Unlike cash salary, stock options cannot be transferred from the individual granted them to anyone else. Nontransferability has two effects that combine to make employee options less valuable than conventional options traded in the market. First, employees forfeit their options if they leave the company before the options have vested.
Second, employees tend to reduce their risk by exercising vested stock options much earlier than a well-diversified investor would, thereby reducing the potential for a much higher payoff had they held the options to maturity. Employees with vested options that are in the money will also exercise them when they quit, since most companies require employees to use or lose their options upon departure.
Recognizing the increasing probability that companies will be required to expense stock options, some opponents are fighting a rearguard action by trying to persuade standard setters to significantly reduce the reported cost of those options, discounting their value from that measured by financial models to reflect the strong likelihood of forfeiture and early exercise. Current proposals put forth by these people to FASB and IASB would allow companies to estimate the percentage of options forfeited during the vesting period and reduce the cost of option grants by this amount.