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Employee Stock Options Must be Treated as Expenses
currivan writes "In a move that's been in consideration for a long time, the Financial Accounting Standards Board (FASB) approved new rules requiring employee stock options to be treated as expenses for reporting purposes. One of the reasons so many tech companies have given options to IT/engineering workers is that until now, they haven't counted against profits in quarterly reports. If markets were truly efficient, this wouldn't make a difference, but in reality, the tech industry is strongly opposed to the rule, though it should please Warren Buffett."
For all of the privately held companies who compete against publicly traded companies who pay out stock options like Monopoly money...this rocks.
The surest way you know a company knows what its doing is if it's turning a profit. This should take one more accounting trick away from the pretenders out there.
When it's granted the option has an intrinsic value of zero, but it's *extrinsic* value is more. Let's say the stock price S is 100, and the option exercise price K is 100 too. You could exercise the option today and make a profit of S-K = 0. That's the intrinsic.
In a year's time, the stock could be worth more than K, in which case the option's intrinsic value will be S-K, or it could be worth less, in which case the intrinsic value will be 0.
The extrinsic value of the option is what it's worth in the market, and presumably what it will be charged at in the accounts. It's calculated by taking the expected intrinsic value at expiry.
For our example, let's imaging there's a 25% change of the stock being worth each of 70, 90, 110 or 130 in on year's time (we'll assume it can't take any other value). The expected value of the stock in a year's time is 100 just as it is now:
E[S] = 0.25 x (70 + 90 + 110 + 130)
= 100
However, the expected intrinsic is...
E[max(S-K,0)] = 0.25 x (0 + 0 + 10 + 30)
= 10
So the value of the option is 10.
Of course, there's more to it than that. The distribution of possible stock prices is continuous. We've also ignored the fact that I'd a dollar today is worth more than a dollar in a year's time. There are theories on how to value these things...
This change would have occurred 10 years ago if Congress hadn't interfered on behalf of companies trying to hide their largesse from shareholders. The rest of the world is in the process of implementing a similar accounting treatment of options. The US would have looked idiotic to have delayed this further.
Yes. The opportunity is worth something all by itself. A stock option grant represents a potential dilution of ownership for current share holders. Think of it this way. Company A has 1 million shares of which you own 100K. You are entitled to a 10% share of the company's profits. The management of the company, in an effort to attract talent, grants 500K more shares. You're ownership now could fall as low as 6.67%. That potential dilution is a real expense to you. Even if it never comes to pass.
"When options are granted, it is usually an option to buy a certain number of shares at today's market value."
/.! When options are granted, you are getting an option to buy a certain number of shares before a certain expiration date. The option to buy shares is a "call" option.
Yay...I get to show off my knowledge of finance on
The "exercise" or "strike" price is the price at which you may buy the stock. It could be below current prices, in which case you'd make an immediate profit. When the strike price is below the current stock price, the option is considered "in the money." When the strike price is above the current market price, you can't make a profit right away and the option would be considered "out of the money." However, just because an option is out of the money doesn't mean it's worthless. Between the growth in the value of the company and the volatility of the stock price, there is still a possibility that it could be in the money before expiration.
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Options DO have value to the FIRM, they will be expensed at the Market closing price of the stock on the day issued. If the company had sold that stock to Joe Public, they would have recorded the revenue, giving it to Joe Employee means they gave away something with value thus an Expense in Accounting terms. Joe Employees doesn't record any loss/gain until the options vest and are exercised. I'll have to read the rules but i hope FASB will let the companies expense the options as they vest not at the time they are given, and if the options never vest they are never expensed.
However, what the FASB rules say and what the IRS rule say can be different. I don't think the IRS has ruled on this area yet, they were seeing if FASB could work it out and maybe jump on that. And yes, companies DO pay taxes, but it's at a fixed rate. They however get lots of tax deductions you and I can't get.
I suspect you will start seeing some funky statements in earnings reports like you mention. I think the Stock Analysts will ignore it, as Earnings are only 1 component of what they measure to "estimate" the stock price. Cash Flow (which options do not affect) is a better measure of how strong a company is for the future.
By the way, I don't think the rank and file techie options are driving this FASB statement, it's more the massive options given to the techie (and other) EXECUTIVES that they are concerned with.
My guess is that they will most likely use The Black-Scholes Option pricing model with a few refinements.
FASB hasn't determined the guidelines for pricing the options, so who knows if they will stick to Black-Shcoles or go with some other valuation of thier own. Around 40% of the companies that issue options to employees already expense them. Also, the companies I worked for that granted options disallowed you to sell the options on the Options Market (after you vest). So, there really isn't access to a Market so Market price is kind of an academic exercise. You must buy and resell the stock to make your money.
HERE
It was Indiana. The reference you cite is talking about a hoax; Indiana actually did present a bill.
IAAA (I am an accountant), and essentially you keep two sets of books, one for accounting purposes and one for tax purposes. Tax accounting is based on cash flows in and out of the company. Since this rule change doesn't effect these cash flows, there shouldn't be any tax implications to this change.
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When options are granted, you are getting an option to buy a certain number of shares before a certain expiration date. The option to buy shares is a "call" option.
You're talking options as the ones traded on the Chicago Borad Options Exchange. Employee stock options are a different beast - unlike market options, they are not transferable and (for the most part) never expire. They are also not clearly defined, because they sometimes void if your employment is terminated, but sometimes they have "triggers" in them whereby they automatically vest upon employment termination unless your employment is terminated "for cause" (i.e. you got fired for doing something bad). The options with triggers are subjectively more valuable, but how (and why?!) you'd want this reflected on the books escapes me completely.
There's a famous formula called the Black-Scoles formula, or variations of this formula, that's being used to value the value of stocks. It works as roughly as follows:
(1)The basic premise is that if the stock is risk free and no dividends are paid out then the stock should appreciate the same way a bond would.
(2) secondly you adjust for risk. The more risky a stock is the more the option is worth. The reason is that the down side risk is limited(the options minimum value is zero) while the up side is theoretically unlimited.
(3) you adjust for expected dividends.
And yes, this is a huge improvement seen from the (fiancial) market's view point. I'm a economics student(I have studied and written reports on a few companies) and let me tell you: Correcting for stock option is often the most annoying aspect lack of disclosure makes valuation very difficult. This is a Good Thing, especialy for small investors that lack the intricate knowledge that is required to unravel the often very complicated options schemes
Lastly, I don't see how this rule will affect anything at all since more likely than not companies will just be publishing two numbers - earnings with stock option adjustment and without. Kinda like EBDTA.
That may be true, but that is a good thing.
1) Investors should be able to look at the financial details and see how much liability there is. As an investor, you may want use stock options as a metric about how a company is run.
2) Stocks options are not 'free money'. When a company gives them away, they create a liability to the shareholds and dilute the value of a company. Just like the US Federal Gov't uses financial trickery to move certain expenses 'off budget', options hide the true financial health of a company.
3) Financial reports represent a snapshot in time. Why shouldn't the expense of options be declared in that snapshot.
4) Options are given out too easily because they don't show up on the bottom line.
5) This is truly common sense because you should always err on the side of full disclosure.
6) Most experts agree that this makes sense, they've agreed for a long long time (pre dot com days). The lobby against it has been from people who are more interested in their personal pocket books than the overall health of the financial system.
Under accrual-based accounting, options are always recorded at cost, so they always have value (par value or stated value plus or minus paid-in capital). Under accrual based-accounting, no buying or selling has to occur for it to be recorgnized and recorded. A mere "promise" satisfies the principle of materiality required to record the event.
In other words, it sounds as if stock options, which weren't liabilities in the past, should now be recorded as liabilities on the accounting period in which they are given. This is important because liabilities that represent expenses are significant to judging the state of the corporation even when they yet haven't actually been expensed yet.
Per FASB guidelines, all corporate accounting in the United States has to be accrual-based. The only entities that still use cash-based accounting are government entitites. With the new ruling, pretty much everyone but the government has to change the way in which stock options are recorded. So your point, though intuitive when thinking in cash terms, is largely inapplicable to everyone but the government.
Mod parent up, Black-Scholes is the most common way to value options. It uses expected volatility in the stock price together with the time horizion until the option expires to calculate a value. A lot of trading sites (etrade, anyway) will calculate option values for you using this model.
http://en.wikipedia.org/wiki/Black_Scholes