Employee Stock Options As An Expense example essay topic

Stock options are a form of compensation granted to an employee, by an employer, in lieu of salary and wages. Stock options grant employees the right to purchase a certain number of shares at a given price. Traditionally, firms have compensated their employees through some combination of salaries, commissions, or bonuses. Less prevalent was compensation tied to firm!'s performance, such as stock and / or stock options. Historically, performance-based compensation was designed for corporate executives and officers of the firm. This form of compensation helped align the interests of management and shareholders.

Stock options encourage managers to maximize shareholder value. Although stock options were once reserved for upper management, there has been a trend to include more employees. Generally, the future purchase price, or strike price, is equal to the market price of the stock at the time of grant. When an employee exercises options, he or she pays the firm the strike price for the shares, regardless of the then- current market price. Employees usually remain with the firm for a specified period before options vest. Upon vesting, the employees may exercise their options.

If an employee leaves the firm, outstanding vested and untested options are forfeited or cancelled. Options not exercised by a date specified in the option contract will expire. When an employee decides to exercise their stock options, they may either purchase the underlying stock at a discounted price or receive an equivalent cash premium. This transfer from the firm to the employee becomes part of the employee!'s taxable income for the year Firms now grant stock options to a much broader range of employees for many reasons. A firm!'s motivation in implementing a stock option plan includes increased employee productivity, the attraction and retention of valuable human capital, reduction of short-run compensation costs, increased cash flows, and higher levels of book income. Individuals, employers, and the government are all affected by the widespread use of stock option compensation.

However another aspect that is affected by stock options is economic forecasters. Income from stock options is more volatile than traditional forms of compensation, such as wages and salaries. Stock options! ultimate value to the employee depends on the future stock performance. Consequently, the stock option value is uncertain at the time of grant. There are two major types of stock options: incentive stock options (ISO! s) and nonqualified stock options (NSO! s). ISO!'s have certain tax advantages for employees.

If required holding periods are met, the spread income (difference between the market and strike price at the time of exercise shares exercised) is treated as a long-term capital gain and taxed at lower tax rate of 20%. If an immediate sale is not made upon exercise of ISO, the event is non-taxable, unless taxpayer is subject to Alternative Minimum Tax. A Nonqualified Stock Option is an option that does not meet tax criteria for an ISO and which is taxed as ordinary income at the time the option is exercised. For a nonqualified stock option, the spread income is treated as wage income to the employee and is taxable.

If NSO shares are not sold immediately upon exercise, then the employee may also be subject to tax upon any realized capital gain or loss. Despite tax advantages of ISO!'s for employees, other factors limit firm!'s overall reliance on them. The most significant tax issue is that firms cannot deduct ISO spread income in the computation of taxable income, but they can deduct NSO spread income. Another type of stock option is employee stock purchase plans (ESPP). Under an ESPP, an employee chooses to have a percentage of their salary withheld for a certain period of time.

At the end, they may use the withheld wages to purchase firm shares at a discount. Stock options play an important role when comparing book income and tax income. At the current time, firms may disclose the value of stock options in their financial footnotes or expense their computed fair value. Companies would only recognize the employee stock options as an expense when the employees exercise the options, not at the grant date. Companies are not required to list stock options as an expense, although the Financial Accounting Standards Board (FASB), which sets U.S. accounting guidelines, views the practice as preferable. Backers of the mandate say doing so would help present a more accurate picture of a company's financial performance.

Since many firms do not expense stock options; the spread income compensation is not deducted from pre-tax book income, but deducted for taxable income. This treatment of spread income is one of many reasons why book and tax income diverge. With the Enron fiasco and investor uneasiness, some firms have begun to expense spread income. FASB has recently announced it would review its accounting standard on employee stock options (FASB Statement No. 123) in the first quarter of 2003, to decide whether to require companies to treat employee stock options as an expense at the point of grant.

A number of companies, such as Coca-Cola, Amazon, General Electric, Bank One and Boeing, have already started to account for stock options in this manner. Prior to 2002, Boeing declared their intention to expense options in order to increase investor confidence in financial statements. Some high-tech companies, such as Amazon. com and Computer Associates, have elected to make the change to expensing stock options. Amazon announced last fall that beginning in fiscal 2003 all stock-based awards granted will be expensed. Computer Associates said it would begin reporting the cost of new stock options as expenses next fiscal year, which starts April 1. A company is, however, required to report its earnings per share on the income statement on a basic and on a 'diluted basis,' the latter taking into account the potential reduction in the ownership of existing shareholders due to the grant and exercise of options.

On the tax side, when an employee exercises an option, the company can take a deduction from its gross income for the gain realized from the option (thereby reducing its corporate income taxes) when the employee recognizes the gain and is taxable thereon. There are two sides to the argument of expensing stock options at the point of grant. People who support the measure contend that expensing stock options at the point would level the playing field between companies that issue employee stock options and companies that pay cash to their employees. Otherwise, the profits of a company that pays its employees in stock options would be unjustly inflated compared o a company that pays its employees in cash. In addition, firms would be more cost-conscious and prudent in granting options to their executives and staff, as they have to recognize stock options as an expense at the point of grant. If these costs of the stock options are not reflected, there may be a tendency to issue too many stock options.

The major argument against expensing stock options is that they are not easily and accurately valued. How does one know how much the stock will be worth in the future? The Black-Scholes model works well if the stock price is stable. But the model is less accurate when it comes to pricing the options in volatile markets such as the ones in which high technology companies participate.

Those opposed to expensing options at the grant date feel that options are not a company expense, but rather costs shifted to shareholders. Footnoting the expense should permit analysts to properly price the stock without distorting a firm's profit and loss statement. Since there are many estimates used in GAAP, recording a major expense calculated using a very complex and potentially inaccurate pricing model would further complicate financial statements. The central issue is that some companies can afford to expense stock options at the grant date and some companies can not afford to expense. As mentioned earlier, Coca-Cola and Bank One were two firms that have started implementing expensing at the grant date. These are companies that are most likely to expense options since they have low stock price volatility and good cash flow.

In contrast, companies, such as cash-strapped high tech start-ups depend upon stock options to attract talent. What is lost in this issue is the shareholder. Stock options were created to align management interests with those of the shareholders. That may not be the case anymore. Company management is focused on actions that drive up the price of their stock in the short term in order to provide continuing value for their own options- actions not focused on growth in long term shareholder wealth. Management should review their company's stock ownership plans with an eye towards increasing equity incentive plans available to their employees, whether options, restricted stock grants or employee stock purchase plans - in order to develop a mix of incentives that will likely result in improved productivity and profitability for the company, its executives, employees and shareholders in the short and the long term!