Theories of Accounting for Stock Options - Research Paper Example

?Theories of Accounting for Stock Options. Introduction The principal debate is whether compensation expenditure should be recognized for both stock options and if it so, the time frame over which it should be allocated. Therefore, stock options are major tools used by companies to attract, retain and motivate their employees. Besides, they have been seen as effective mechanism for aligning the interests of the managers more closely with those of the shareholders. The theories used in the accounting of stock option are measured using different models which include; the intrinsic value, historical cost method where companies repurchase their own stock and utilize such treasury to satisfy the exercise of the stock options. Fair value model, lattice model and finally minimum value method which is based upon the someone’s willingness to purchase a call option on a share of stock at the current fair value of the stock with the right to postpone payment of the exercise until the end of the options period, ignoring the volatility of the underlying stock in valuation calculation. This has necessitated the emergence of alternative incentive methods to premium cash thus employee stock options. Any stock option with exercise price higher than the price of the underlying stocks at the exercise date are exchanged for new ones with lower exercise price because companies have to account for the stock issued to their employees. But the companies have to account for them although they do not incur any costs to grant the options. Guides and standards on how such transactions are accounted for in the books of the company have to be provided. Stock option compensation that needs to be looked at is the backdating of employee stock option and how it affects the company. Agency theory argues that compensation policy should provide management with incentives to select and implement actions that add shareholder wealth. Discussion Pertaining the use of the intrinsic value method of accounting for stock options, a company is to value stock options based on their intrinsic value at that juncture they were granted. Intrinsic value refers to the difference between the stock’s market price on the grant date and also including the exercise price at which the employees can use the option to purchase stock. Incase the stock’s market price is slightly higher than the option exercise price, therefore, the stock option’s value is the difference between the two. Realizing the shortcomings of the method there is need to look for a more comprehensive and efficient method of stock options .By using this method it will result in no compensation expense since we grant employees options with exercise prices same as the fair market value of the underlying stock at the time of the grant. Fair value was encouraged to be used but it was not a mandatory requirement to be used by the companies as stipulated by the Financial Accounting Standards Board (FASB). The fair value accounting approach valued stock options basing on various factors that establish the underlying value. This is because the companies are to outlay for option grants based on the fair value of the options that were expected to vest on the date it granted them. In December 2004, FASB issued a Statement of Financial Accounting Standards (Statement) No. 123(R), Share-Based Payment. Statement 123(R) replaced Statement 123, Accounting for Stock-Based Compensation, and was consequently effective for public companies as of July 1, 2005. It was effective for non-public companies as of January 1, 2006. The company had an option of either using Black-Schole option pricing model or the binomial option so as to come up with the options fair value. However, if the company continues with the intrinsic value of the approach they required to avail additional closure in the footnotes to their financial on what the expenses would have been with fair value approach. Under Statement 123, the company is only allowed to disclose information on the effects of expensing the fair value of stock options granted. Every stock based compensation transactions are to be accounted for only using fair value method. FASB had a strong feeling that by excluding Opinion 25’s intrinsic value method there will be an improvement in the comparability of reported financial information, simplify GAAP accounting and most importantly addressing the concerns of users of financial statements who believe that Opinion 25 does not comprehensively represent the economics of transactions that include employee stock options. According to Apostolou and Crumbley (2005), the proponents of expensing stock option are of the opinion that employee stock options represent a form of compensation that would be expensed just like any other form of compensation. Many top level executives have argued that employee stock options which need no cash outlay are not to the equality of cash wages, thus forcing the companies to expense stock options will incessantly destroy the profitability of many companies and deter the use of employee stock options. The hurdle with many companies is that the management and their auditors will often sometimes overstate the value of the stock options by manually applying inputs to the Black-Scholes model. In determining the fair value of employee stock options various models are used. Statement 123 defines fair value standard as the “The amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” Quoted market prices of the same actively traded investments are perceived as the best evidence of fair value. If the observable market prices are missing then the Black-Scholes and other option pricing models are brought into play as acceptable valuation techniques for establishing the fair value of employee stock options, because they are determined by principals of economic theory generally accepted by valuation experts. This is based on the fact that Black-Scholes module assumes that options are transferable and marketable. Employee stock options are not transferable and can only be converted to monetary units through exercise. Besides, neither can the non-invested employee stock options be bought nor sold. This is because the holder of a nontransferable option can only receive the intrinsic value of an option at any point in time and therefore, will be incentivized to exercise early should the original stock price attain an attractive price level. This results in the likelihood of expected life of the estimated value of an employee stock option to be much shorter than its maximum term (Garlick, 2005). The aim of the option pricing model is to estimate the market expectations that are likely to be manifested in a current negotiated exchange price for the option thus determining the fair value of an option. Expectations about the future are argued on the baseline of past experiences; however, historical volatility is not the only pointer of expected volatility thus unadjusted historical experience is a relatively poor predictor of future expectations. In 1995, SFAS 123, Accounting for Stock-Based Compensation, made it clear that the beginning point for the accounting process was to be the so-called fair value established at the time of the grant of options, and it was generally presumed to be determined by the Black-Scholes option pricing model. Fair value, once attained was then amortized over the employees’ service periods. This long-winded mathematical configuration has been met with universal disapproval, and FASB has since tried to disentangle itself from the standard’s implications (Briloff, 2003). The use of fair value method in accounting for employee stock options gradually decreased our net income. This is because currently, the company accounted for options using the intrinsic value method which does not create need for compensation expense because we grant employee options with exercise prices equal to the fair market value of the underlying stock at the time of the grant. Consequently, if we had used the fair value method for accounting for stock options granted to employees using the Black-Scholes option valuation formula, our net income for the six months ended July 30, 2012, would have been reduced by $ 1.5 million from $ 5.0 million to $ 3.5 million. When we adopt FAS 123R in the first quarter of 2013, we will have the continuing accounting charges significantly more than those we would have recorded under the current method of accounting for stock options. It will result in realizing a materially adverse effect on our companies operating results (DTS, 2005). Next model used in the accounting of stock options is the Lattice model. According to FASB from 2006 after changing its approach to accounting options it is a requirement that all companies to expense their stock. The Lattice method is another way of arriving at an option value. However, although it utilizes the similar input as the Black-Scholes option pricing model, the model utilizes more varied number adjustments to more accurately reflect real world event. The critics of the failure to expense options on the income statement have become more vocal in the recent years because of the rampant concern over the not to be trusted accounting practices at companies accused of perpetrating fraud. In Berkishere’s 1998 annual report, he says, “Existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are huge and an increasing expense at many corporations.” He labels this accounting policy as “outrageous” and an “egregious flaw in accounting procedure.” There are various ways of computing the fair value of stock options. One of the most frequently used is the Black-Scholes option pricing model whish was developed I 1973 to compute the value of publicly traded European stock option. Another method is binomial option pricing but this method handles more option plan provisions than the Black-Scholes model does. According to Garlick the use of this method was necessitated because Statement 123(R) does not recognize the Black-Scholes model to be an acceptable means of computation. Unlike the formula used to calculate option value under Black-Scholes, the lattice model does not utilize a straightforward mathematical equation. In contrast, the lattice model uses an iterative approach that involves generating a large number of possible outcomes and assigning a probability to each outcome. The complexity and the deepness of the calculations typically require computer-based models to determine values. Lattice model uses the same principle as the Black-Scholes by reflecting post-vesting employment termination behavior in addition to other adjustments designed to incorporate certain distinctiveness of employees share options and similar instruments. The lattice model is flexible in terms of dividends, over the options contractual terms, estimates of expected option-exercise patterns also during the contractual term (Apostolou & Crumbley, 2005). In contrast to the formula used to calculate option value under Black-Scholes, the lattice does not use incorporate direct mathematical equation therefore, it uses the iterative approach that entails generating a large number of possible outcomes and assigning a probability to each outcome realized. With regards to a company transitioning to the new guidance, Statement 123(R) created a provision for three methods. First is the modified prospective method, by following Statement 123 up to the effective date of Statement 123(R) by companies, then it is necessary to expense all stock granted and vested after the effective date. However, stock options granted and they are not yet vested before the effective date of Statement 123(R) are incorporated in the expense to be recognized thus making it a requirement for public companies. Next is modified retrospective. Here the company may decide to restate their previously reported years’ financial statements to be in conformity with the new provisions of Statement 123(R). Finally it is the prospective method. This is well illustrated where particular nonpublic companies are authorized to follow Statement 123 for stock options granted before Statement 123(R)’s effective date and follow Statement 123(R) for all stock options issued after the effective date. This concept of Statement 123(R) has and will continue having a tangible effect on the companies that issue large numbers of stock options to several employees (Garlick, 2005). When accounting for stock options the use of US-GAAP is important. APB opinion 25 refined the measurement date and value for stock options for basing on fixed and factors. Moreover, accounting controversy for stock options is always eminent because of the different points of view about their economic implications. On one side there are those who are of the belief that the stock options grants should not imply the recognition of an expense while on the contrary others are of the opinion that stock options are a form of a remuneration given in the exchange for services offered by the employees therefore it must be recognized as an expense. The arguments that usually referred to against the expensing of stock options include; stock options do not meet the definition of an expense. Secondly, stock options are perceived as capital transaction. Thirdly, the potential dilution of the stock options is already manifested comprehensively in the diluted earnings per share. Fourthly, the divulgation of stock options is well thought-out as adequate. Fifthly, the stock options cost cannot be approximated reliably. Finally, expensing of stock options will destroy infant and new companies thus having severe economic consequences because start- up companies are often cash-strapped (Alves, 2010). Conclusion The proponents of non-expensing are of the opinion stock options are capital transactions with shareholders thus being cash friendly to the company making it not to fit the definition of an expense. Consequently, stock options can not be measured more precisely for financial statement purposes besides making companies to stop using it because they damage new and progressing businesses. Granting of equity incentives is a vital mechanism for rewarding employees for their exemplary performance therefore tying the employee motivation to the interests of shareholders. On the contrary proponents argue that since stock options are issued in exchange for the employees services thus being recorded in the company’s account in the same way as cash remuneration in addition to meeting the definition of an expense. Most stock options have an exercise price same as the stocks market price on the grant date, the company did not have an account for them as compensation. The FASB takes into account that the valuation technique used should be applied in a way that is consistent with the fair value measurement objective and besides a model such as the Black –Scholes should be adjusted to account for the specific characteristics that are associates with share options and similar instruments granted to employees. Both FASB and IASB are both are of the belief that expenses are realized when companies give stock options to the employees as a part of the compensation package. It is now almost globally accepted that stock options are an expense to the company that need to be accounted for and the most suitable method for valuing stock options is by reference to fair value, rather than their historical, intrinsic or minimum value. To sum up absence of stock options expense can result in stock mispricing thus not achieving the true cost of stock option grants. However, there is still some debate on accounting for stock options thus rendering it a controversial and contested topic. Reference List Alves, S. (2010). The Controversy over Accounting for Stock Options: A Literature Review. International Research Journal of Finance and Economics (53), 2-19. Apostolou, N. G., & Crumbley, D. L. (2005, August 12). The CPA Journal. Retrieved December 1, 2012, from Accounting for Stock Options: http://www.nysscpa.org/cpajournal/2005/805/essentials/p30.htm Briloff, A. J. (2003, December 15). The CPA Journal . Retrieved December 1, 2012, from Accounting For Stock Options: http://www.nysscpa.org/cpajournal/2003/1203/nv/nv4.htm DTS. (2005, August 5). Accounting for employee stock options using the fair value method wil reduce our net income. Retrieved December 2, 2012, from Wikinvest: http://www.wikinvest.com/stock/DTS_%28DTSI%29/Accounting_Employee_Stock_Opt ions_Using_Fair_Value_Method Garlick, G. (2005, February 8). Valuation of Employee Stock Options under FASB Statement 123. Retrieved 2012 2, 2012, from Cogent valuation: http://www.cogentvaluation.com/pdf/valuationofemployeestockoptionsunderfasb123.pdf Read More