Stock Options from the Company Perspective

Last week I talked about stock options and how they work from the employee’s perspective. This week I want to spend a little time talking about how they work from the company’s perspective.

Current accounting standards take the view that when a stock option is granted, something of value has been given to the employee and that value needs to be recognized as an expense to the company. This creates three basic issues that must be dealt with when accounting for stock options.

  1. What is the value of the option at the date of grant?
  2. When should the expense be recognized?
  3. What do I do with the difference between the value I put on the option at the grant date and the value the employee gets from the company when the option is actually exercised?

Accounting standards say we should first look to an actively traded market when determining the value of a financial instrument such as a stock option. And while stock options are actively traded on many markets, the problem for us accountants is that the terms of the options traded on a market are usually significantly different from the terms of employee stock options. While both have an exercise price for the option, traded options generally have no vesting period and usually have much shorter (less than a year) exercise periods, so the market prices of options are not relevant in determining the value of employee stock options.

Instead, we use a financial model, the most common of which is called the Black-Sholes model named after Fisher Black and Myron Scholes who developed the model and first published a paper on it in 1973. For those of you not versed in finance speak, a model is just another word for guess, but I don’t think the FASB would appreciate me pointing out that accounting standards require us to book expenses based on a guess. But I digress.

Once the model guesses the value of the option, we then need to decide when to recognize that value as expense. When it comes to compensation, we should generally recognize such expense over the time period the employee is working for the compensation. For salary earned over a week it should be recognized as expense that week. For stock options, we look at the vesting period of the option. If the vesting period is two years, then we recognize the value of the option as compensation expense ratable over that two year period. Of course, not every employee granted stock options stays for that two year period, so we have to estimate (guess) how many employees will forfeit their options over the vesting period and not recognize expense for those employees. Finally, we have to periodically look at the actual number of employees leaving early and adjust the forfeiture rate (re-guess) over time if our original rate (guess) was wrong.

Finally we have to deal with the difference between the guessed, I mean modeled, value of the option we used to book expense and the amount we actually paid the employee when they exercise the option. Keep in mind that the odds that the model value exactly equals the value the employee receives when they exercise the options are about the same as your odds of winning the Power Ball lottery, so we will always have a difference in value to deal with. Accounting standards view that difference as an equity transaction between the employee and the company not as compensation expense (note that tax laws view it differently resulting in a permanent difference between the accounting records of a company and the tax records of that same company).

Let’s assume the company valued the option at $5 and recognized that much expense over the vesting period. In the first scenario let’s assume the company did well and the stock price went up $10 so the employee received $10 of value when they exercised the option. In this case the company has to recognize an additional $5 as a debit (decrease) to stockholders equity, just like they would if they went out and bought shares on the open market from other stockholders. In the second scenario let’s assume the company did not do as well so the stock price only went up $2. The employee still exercises their option, but in this case the company has to offset the $5 they accrued for compensation expense. The $3 difference between that amount accrued and the amount the employee received is recognized as a credit (increase) in stockholders equity.

Obviously, this is a very simplified discussion of the accounting for stock options; the rules are almost a couple of a hundred pages long and accounting firms have written guides on the topic that can run over 400 pages. I hope however, these two blogs have given you a sense of the difference between the way options are viewed by employees and the way they are viewed by companies which is part of the reason they have lost some of their luster as the preferred form of share-based compensation over the past few years and, as a result, why the use of restricted stock is on the upswing. In the future, I will spend some time taking about how restricted stock works and how it functions very differently from both the employee and the company perspective.

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