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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."
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.
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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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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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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.