Pros & Cons of Expensing Stock Options
Companies expense stock options when they treat their use of such options as part of the compensation package to the recipient employees, recording it as such in their books, thereby reducing reported net income.
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History
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In the 1990s and early in the 21st century there was a good deal of debate over whether the Financial Accounting Standards Board, which defines generally accepted accounting principles in the U.S., ought to require such expensing. Despite the critics, the FASB did in 2004 adopt a revision of its Standard 123 that requires a "public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair
value of the award (with limited exceptions)."
Function
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The expensing of stock options serves several functions. First, it gives investors or potential investors in a firm a better sense of the real expenses the firm is incurring than they would get otherwise. Second, it increases comparability. Consider a competitive situation in which two firms are in effect paying their high-ranking software engineers equivalent salaries. But firm RST is paying them half in cash, and half in options. Firm UVW is paying all cash. Investors can discover the underlying economic reality, that the level of compensation is comparable, because of the fair value treatment of the options grants. Finally, it improves international comparisons, because the new standard 123 is more similar to the International Financial Reporting Standards than was the older FASB system.
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Considerations
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Critics of expensing argue that financial analysts follow the cash in their reading of balance sheets and other financial statements. The options expense is a non-cash transaction that analysts would likely ignore in coming to grips with the underlying realities.
Accordingly, critics argue that expensing would be an unnecessary burden upon those companies that most often employ options as a critical part of their hiring strategy. High-tech firms offer options to "multiple levels of employees with two purposes in mind," both to attract new employees and to motivate those already on board, according to Charles J. McPeak, an experienced accountant writing in the Graziadio Business Report in 2002. He believes these are the firms that would be hurt.
Reply
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A later issue of the Graziadio Business Report carried a reply to McPeak's argument, by Steven Ferraro, an Associate Professor of Finance at Pepperdine University. It should not be the method of sophisticated analysts that determines what is accepted accounting practice, Ferraro said. Consideration, too, should be given to the less sophisticated, to day traders, and others who "spend more time investigating refrigerators before they buy one than they do investigating a stock before they buy it." These investors need the pertinent information presented in the most transparent form, which requires the expensing of options.
Variation
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Though most publicly owned companies do now expense options, the method of valuation they use varies. The FASB has allowed room for divergent approaches, writing: "A lattice model ... and a closed-form model ... are among the valuation techniques that meet the criteria required by this Statement for estimating the fair value of employee share options."
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References
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