Should Stock Options Be Expensed?
Accounting rules mandate that corporations record an expense for stock options that have been granted to the employees of the firm as a form of compensation. Although such options do not result in an actual cash outlay, they do result in the creation of more shares, which dilutes existing shareholders as well as foregone revenue.
Other People Are Reading
-
Basics
-
Employee stock options are issued as a form of compensation. When the company stock is trading at $15 per share, for instance, an employee may be granted a call option with a strike price of $20 for 20,000 shares which kicks in two years from the date of issuance. This means that in two years the worker can purchase 20,000 shares of the firm for $20 each. If each share is trading at $25 at that point in time, the option holder would earn a significant sum of money: $5 per share, or $100,000 in total.
Benefits
-
Companies issue stock options to motivate their employees to work harder, to retain them over extended periods of time and to create a sense of unity among the workforce. In the prior example, the worker must still be employed by the firm in two year's time or she will lose the right to the option. Furthermore, the option provides an incentive for her to work harder, since the higher the firm's stock price rises, the more she will benefit from exercising the options. If the firm's stock is trading at less than $20 in two years, the options will expire worthless.
-
Downside
-
Stock options must be expensed because there are indirect costs associated with their issuance. If the employee exercises the options in the prior example and wishes to buy shares at $20, these shares will be issued, or created, from scratch. Even though the firm is free to create these shares, selling them to the employee at $20 each means there is a significant foregone revenue. The employee would only exercise the options if the shares are trading above $20 on the free market, which means the firm could have sold the same shares for more money to ordinary investors and obtained more cash. Furthermore, additional shares mean that there will be more shareholders sharing profits in the future, thus diluting existing investors.
Accounting Treatment
-
Accounting rules mandate that the firm issuing the options record the foregone revenue as a form of expense. If shares are issued and sold at $20 when they were trading at $25 in the open market, the issuing firm would record an expense of $5 per share. Therefore it is impossible to know how much of an expense will be recorded for stock options ahead of time. If the shares are trading below the option's strike price when the option expires, no new shares will be issued and no expense recorded. On the other hand, there is no theoretical limit on how high the stock price can climb and how much of an expense the firm will be forced to record. This uncertainty makes stock option expensing a headache for accountants.
-
References
- Photo Credit Jupiterimages/Comstock/Getty Images
