Regnskap For Ansattes Aksjeopsjoner In India

ABC av personaloptjonsplaner Tiltrer, belønner og motiverer en talentfull medarbeider er hovedformålet med ESOP (Employee Stock Option Plans). For å beholde menneskekapitalen investerer selskaper i India i dag mange penger. Et slikt medium er å motivere medarbeideren ved hjelp av ESOP. I henhold til denne ordningen blir det gitt et alternativ til den ansatte for å erverve aksjer i selskapet. Disse aksjene er kjent som opsjoner og gis av arbeidsgiver basert på ytelsen til den ansatte. Selskaper tilbyr aksjer som en ansatt fordel og som utsatt kompensasjon. I henhold til SEBIs retningslinjer bør en ansatt være fast ansatt bosatt i India eller utenfor India. Det inkluderer også selskapets direktør han kan eller ikke kan være en heltidsdirektør. Den grunnleggende ideen om å gi opsjoner til ansatte i begynnelsen av dagen var å spare kontantkompensasjoner. Det var en måte å motivere medarbeiderne på, og til og med for å spare penger for noen av de kontantstrammede selskapene. Disse planene er utover lønnen til den ansatte, men ikke i pengeform direkte. Senere tok konseptet motivasjon opp og opprettholdelse til spredning av ESOP på tvers av selskapets vertikaler. Dette er i utgangspunktet låsen i perioden for den ansatte. Det er en bestemt dato som aksjeopsjonen kan utøves på. For eksempel: Mr. Deepak har fått opsjonsopsjon fra selskapet for en opsjonsperiode på 3 år i år 2. februar 2012. Dette betyr at inntjeningsdato er 2. februar 2015. Prisen hvorav 500 aksjer ble tilbudt til Deepak var Rs 250 hver. Denne prisen er innløsningsprisen. Dette betyr at den 2. februar 2015 kan han utøve sin rett til å kjøpe aksjen, avhengig av forholdene. La oss si at prisen på aksje den 2. februar 2015 er 650, dette vil resultere i en gevinst på Rs 400 hver, noe som gir en fortjeneste på Rs 2,00,000 til den ansatte, hvis han utøver opsjonen etter 3 år. Skatteimplisering av opsjonsplaner: Inntil 1995 var det ingen bestemmelse om å beskatte ESOP. Men i år inntektsskattemyndighetene klargjort ved hjelp av et sirkulært at disse alternativene som gjør aksjene til selskapet tilgjengelig for ansatte til lavere enn markedsprisen, vil tiltrekke seg skatt. Først og fremst er det arbeidstakerens skjønn. Utøvelse av opsjon eller avvisning er helt avhengig av den ansatte. ESOP-fordeler utgjør en del av ansattes lønn og er skattepliktige som en perquisite. Beregningen er basert på markedsverdien av aksjen på opsjonsdagen og den opptjente prisen. Vanlige innbyggere er ansvarlige for å betale disse skattene på grunnlag av global inntekt. For selskaper notert i India For alle selskapene som er notert i India, belastes 15 prosent av skatten med kortsiktige kapitalgevinster (STCG). Langsiktig kapitalgevinstskatt (LTCG) oppstår ikke i dette tilfellet. For selskaper notert utenfor India: For selskapene som ikke er notert i India, men notert i andre børser over hele verden, vil kortsiktig kapitalgevinst bli lagt til som en del av lønn og skatt belastes ut fra lønnsplattene. LTCG belastet er 20 prosent sammen med indeksering. For eksempel: Arbeidsgiver har gitt mulighet for tildeling av totalt 400 aksjer for de neste 4 årene for alle kvalifiserte medarbeidere. Innløsningskursen er Rs 100 og startdato for tildeling er 1. juli 2010. Raj, en av selskapets ansatte, er tildelt 100 aksjer 1. juli 2010, på opptjeningsdagen er aksjekursen Rs 500. Han selger disse aksjene på Rs 1500 på 1 desember 2011. SKATTE på tidspunktet for tildeling: STCG vil være (500-100) 100 20 Rs 8000 (Tatt i betraktning Mr Raj er i 20 prosent brakett). SKATT ved salgstidspunktet: (1500-500) 10015 Rs 15000 InvestmentYogi er en ledende personportal. Ansvarsfraskrivelse: All informasjon i denne artikkelen er gitt av InvestmentYogi og NDTV. Resultatet er ikke ansvarlig for nøyaktigheten og fullstendigheten til det samme. For siste gang: Aksjeopsjoner er en kostnad Det er tid for å avslutte debatten om bokføring av aksjeopsjoner Kontroversen har gått alt for lenge. Faktisk reglene for rapportering av aksjeopsjoner dateres tilbake til 1972, da regnskapsprinsippstyret, forgjengeren til Financial Accounting Standards Board (FASB), utstedte APB 25. Regelen angav at kostnaden av opsjoner ved bevilgningen datoen skal måles ved egen vurdering av forskjellen mellom den nåværende markedsverdien av aksjene og oppløsningsprisen på opsjonen. Under denne metoden ble det ikke tildelt opsjoner når opsjonsprisen ble satt til dagens markedspris. Begrunnelsen for regelen var ganske enkel: Fordi ingen kontanter skifter hender når tilskuddet er gjort, er utstedelse av aksjeopsjon ikke en økonomisk signifikant transaksjon. Det var mange som tenkte på det tidspunktet. Hva mer var, var lite teori eller praksis tilgjengelig i 1972 for å veilede selskaper i å bestemme verdien av slike uutviklede finansielle instrumenter. APB 25 var foreldet innen et år. Publikasjonen i 1973 av Black-Scholes-formelen utløste en stor boom i markeder for børsnoterte opsjoner, en bevegelse forsterket av åpningen, også i 1973, av Chicago Board Options Exchange. Det var absolutt ingen tilfeldighet at veksten i de handlede opsjonsmarkedene ble speilet av en økende bruk av aksjeopsjonsstipendier i leder - og ansattes kompensasjon. Nasjonalt senter for ansattes eierskap anslår at nesten 10 millioner ansatte mottok aksjeopsjoner i 2000 mindre enn 1 million i 1990. Det ble snart klart i både teori og praksis at opsjoner av noe slag var verdt langt mer enn egenverdien definert av APB 25. FASB initierte en gjennomgang av opsjonsregnskapsregnskapet i 1984, og etter mer enn et tiår med oppvarmet kontrovers, utgitt SFAS 123 i oktober 1995. Det anbefalte ikke at selskapene skulle rapportere kostnaden for opsjoner gitt og for å bestemme sin rettferdige markedsverdi ved hjelp av alternativ-prismodeller. Den nye standarden var et kompromiss som gjenspeiler intensiv lobbyvirksomhet av forretningsfolk og politikere mot obligatorisk rapportering. De hevdet at utøvende aksjeopsjoner var en av de avgjørende komponentene i amerikansk ekstraordinær økonomisk renessanse, så ethvert forsøk på å endre regnskapsreglene for dem var et angrep på Americas enormt vellykket modell for å skape nye virksomheter. De fleste selskaper valgte uunngåelig å ignorere anbefalingen om at de motsatte seg så voldsomt og fortsatte å registrere kun egenverdien ved tildelingsdato, vanligvis null, av deres opsjoner på stock options. Deretter gjorde den ekstraordinære bremsen i aksjekursene kritikere av opsjonsutgiftene, ligner spoilsports. Men siden ulykken har debatten returnert med hevn. Skarpheten av bedriftens regnskapskandaler spesielt har avdekket hvor uvirkelig et bilde av deres økonomiske resultater mange selskaper har malt i sine regnskap. I økende grad har investorer og regulatorer kommet for å innse at opsjonsbasert kompensasjon er en stor forvrengende faktor. Hadde AOL Time Warner i 2001 for eksempel rapportert ansatteopsjonsutgifter som anbefalt av SFAS 123, ville det ha vist et driftsunderskudd på rundt 1,7 milliarder i stedet for de 700 millioner i driftsinntektene som det faktisk rapporterte. Vi mener at saken for kostnadsutgifter er overveldende, og i de følgende sidene undersøker og avviser vi hovedkravene fremsatt av de som fortsetter å motsette seg det. Vi demonstrerer at, i motsetning til disse ekspertsargumentene, aksjeopsjonsstipendier har virkelige kontantstrømimplikasjoner som må rapporteres, at måten å kvantifisere disse implikasjonene er tilgjengelig, er at fotnoteopplysning ikke er en akseptabel erstatning for å rapportere transaksjonen i inntektene oppstilling og balanse, og at full anerkjennelse av opsjonskostnader ikke trenger å emasculate incentiver av entreprenørskapsvirksomheter. Vi diskuterer da bare hvordan bedrifter kan gå om å rapportere kostnaden av opsjoner på resultatregnskap og balanser. Fallacy 1: Aksjeopsjoner representerer ikke en reell kostnad Det er et grunnleggende prinsipp for regnskapsføring at regnskap skal registrere økonomisk vesentlige transaksjoner. Ingen tviler på at handlede alternativer møter det kriteriet tusenvis av dollar verdt er kjøpt og solgt hver dag, enten i over-the-counter markedet eller på utveksling. For mange er imidlertid aksjeselskapsstipendier en annen historie. Disse transaksjonene er ikke økonomisk signifikante, argumentet går fordi ingen kontanter skifter hender. Som tidligere amerikanske eksekutivdirektør Harvey Golub satte den i en 8. august 2002, Wall Street Journal artikkel, er opsjonsopsjoner aldri en kostnad for selskapet, og derfor bør det aldri bli regnskapsført som en kostnad i resultatregnskapet. Den stillingen tåler økonomisk logikk, for ikke å nevne sunn fornuft, på flere måter. For en start trenger verdioverføringer ikke å innebære overføring av kontanter. Mens en transaksjon som involverer en kvittering eller betaling er tilstrekkelig til å generere en opptakbar transaksjon, er det ikke nødvendig. Hendelser som utveksling av aksjer for eiendeler, signering av en leieavtale, tilveiebringelse av fremtidig pensjon eller feriefordeler for inneværende periode ansettelse, eller kjøp av materiale på kreditt alle utløser regnskapstransaksjoner fordi de innebærer overføringer av verdi, selv om ingen kontanter skifter hender på det tidspunktet transaksjon oppstår. Selv om ingen kontanter skifter hender, utstedes aksjeopsjoner til ansatte med et offer av kontanter, en mulighetskostnad, som må regnskapsføres. Hvis et selskap skulle gi aksjer, i stedet for opsjoner, til ansatte, ville alle være enige om at selskapets kostnader for denne transaksjonen ville være det kontanter det ellers ville ha fått hvis det hadde solgt aksjene til dagens markedspris til investorer. Det er akkurat det samme med aksjeopsjoner. Når et selskap gir opsjoner til ansatte, gir det muligheten til å motta kontanter fra garantistene som kan ta de samme alternativene og selge dem i et konkurransedyktig marked for valg til investorer. Warren Buffett gjorde dette poenget grafisk i en kolonne i Washington Post 9 april 2002 da han sa: Berkshire Hathaway vil gjerne motta alternativer i stedet for kontanter for mange av de varer og tjenester vi selger Amerika. Å gi opsjoner til ansatte i stedet for å selge dem til leverandører eller investorer via garantistyrker innebærer et faktisk tap av kontanter til firmaet. Det kan selvsagt være rimeligere hevdet at kontanter som gis ved å utstede opsjoner til ansatte, i stedet for å selge dem til investorer, kompenseres av det kontanter selskapet opprettholder ved å betale sine ansatte mindre penger. Som to anerkjente økonomer, Burton G. Malkiel og William J. Baumol, notert i en 4 april 2002, Wall Street Journal-artikkel: Et nytt entreprenørfirma kan ikke være i stand til å yte den kontantkompensasjon som trengs for å tiltrekke fremragende arbeidstakere. I stedet kan det tilby aksjeopsjoner. Men Malkiel og Baumol følger dessverre ikke sin observasjon til sin logiske konklusjon. For hvis kostnaden for aksjeopsjoner ikke er universelt innlemmet i måling av nettoinntekt, vil selskaper som gir opsjoner, undergrave kompensasjonskostnadene, og det vil ikke være mulig å sammenligne lønnsomhet, produktivitet og kapitalbasert tiltak med økonomisk tilsvarende selskaper som bare har strukturert deres kompensasjonssystem på en annen måte. Den følgende hypotetiske illustrasjonen viser hvordan det kan skje. Tenk deg to selskaper, KapCorp og MerBod, som konkurrerer i nøyaktig samme bransje. De to er bare forskjellig i strukturen av deres kompensasjonspakker. KapCorp betaler sine arbeidere 400.000 i total kompensasjon i form av kontanter i løpet av året. I begynnelsen av året utsteder det også gjennom en tegningsordning 100.000 verdier av opsjoner i kapitalmarkedet, som ikke kan utøves i ett år, og det krever at ansatte skal bruke 25 av kompensasjonen til å kjøpe de nyutstedte opsjonene. Netto kontantstrøm til KapCorp er 300.000 (400.000 i kompensasjonskostnad mindre enn 100.000 fra salget av opsjonene). MerBods tilnærming er bare litt annerledes. Den betaler sine arbeidere 300.000 i kontanter og gir dem direkte 100.000 verdier av opsjoner i begynnelsen av året (med samme ettårig treningsbegrensning). Økonomisk sett er de to posisjonene identiske. Hvert selskap har betalt totalt 400.000 i erstatning, hver har utstedt 100.000 verdier av opsjoner, og for hver netto kontantstrøm utgjør 300.000 etter at kontantene mottatt fra utstedelsen av opsjonene trekkes fra kontanter brukt til kompensasjon. Ansatte hos begge selskapene har samme 100.000 opsjoner i løpet av året, og gir samme motivasjon, incitament og retensjonseffekter. Hvor legitim er en regnskapsstandard som tillater to økonomisk identiske transaksjoner til å produsere radikalt forskjellige tall. Ved utarbeidelsen av årsregnskapet vil KapCorp bestille kompensasjonskostnader på 400.000 og vise 100.000 opsjoner i balansen på en egenkapitalkonto. Hvis kostnaden for opsjoner utstedt til ansatte ikke regnskapsføres som en kostnad, vil MerBod imidlertid bestille en kompensasjonskostnad på bare 300.000 og ikke vise noen opsjoner utstedt i balansen. Forutsatt ellers identiske inntekter og kostnader, vil det se ut som om MerBods inntjening var 100.000 høyere enn KapCorps. MerBod vil også synes å ha en lavere egenkapitalbase enn KapCorp, selv om økningen i antall utestående aksjer i hvert fall vil være det samme for begge selskapene dersom alle opsjoner utøves. Som følge av lavere kompensasjonskostnad og lavere egenkapitalposisjon, vil MerBods ytelse ved de fleste analytiske tiltak ser ut til å være langt overlegen til KapCorps. Denne forvrengningen er selvsagt gjentatt hvert år at de to firmaene velger de forskjellige kompensasjonsformene. Hvor legitim er en regnskapsstandard som tillater to økonomisk identiske transaksjoner til å produsere radikalt forskjellige tall. Fallacy 2: Kostnaden for ansattes aksjeopsjoner kan ikke estimeres Noen motstandere av opsjonsutgifter forsvarer sin posisjon på praktisk, ikke konseptuell grunnlag. Alternativ-prismodeller kan virke, sier de, som en veiledning for verdsettelse av børsnoterte alternativer. Men de kan ikke fange verdien av ansatteopsjoner, som er private kontrakter mellom selskapet og ansatt for illikvide instrumenter som ikke kan fritt selges, byttes, pantsatt som sikkerhet eller sikres. Det er sant at en instrumentets mangel på likviditet generelt vil redusere verdien til innehaveren. Men innehaverens likviditetstap gjør ingen forskjell på hva det koster utstederen å skape instrumentet med mindre utstederen på en eller annen måte drar nytte av mangel på likviditet. Og for aksjeopsjoner har fraværet av et flytende marked liten effekt på verdien til innehaveren. Den flotte skjønnheten av alternativ-prismodeller er at de er basert på egenskapene til den underliggende aksjen. Det er nettopp hvorfor de har bidratt til den ekstraordinære veksten av opsjonsmarkedene de siste 30 årene. Black-Scholes-prisen på et alternativ er lik verdien av en portefølje av aksjer og kontanter som styres dynamisk for å kopiere utbetalingene til det alternativet. Med en helt likvide beholdning kunne en ellers ubegrenset investor helt sikre en opsjonsrisiko og trekke ut verdien ved å selge kort replikerende portefølje av aksjer og kontanter. I så fall vil likviditetsrabatten på opsjonsverdien være minimal. Og det gjelder selv om det ikke var noe marked for handel alternativet direkte. Likviditetenes mangel på markeder i aksjeopsjoner fører derfor ikke til rabatt i opsjonsverdien til innehaveren. Investeringsbanker, kommersielle banker og forsikringsselskaper har nå gått langt utover den grunnleggende, 30-årige Black-Scholes modellen for å utvikle tilnærminger til prising av alle mulige alternativer: Standard seg. Eksotiske. Alternativer handlet gjennom mellommenn, over disk, og på utveksling. Alternativer knyttet til valutasvingninger. Alternativer innebygd i komplekse verdipapirer som konvertibel gjeld, foretrukket lager eller gjeldsgjeld som boliglån med forskuddsbetaling eller rentedeksler og - gulv. En hel underindustri har utviklet seg for å hjelpe enkeltpersoner, selskaper og pengemarkedsforvaltere å kjøpe og selge disse komplekse verdipapirene. Nåværende finansiell teknologi tillater absolutt at bedrifter skal inkludere alle funksjonene til ansattes aksjeopsjoner i en prismodell. Noen få investeringsbanker vil til og med sitere priser for ledere som ønsker å sikre eller selge sine aksjeopsjoner før opptjening, hvis deres selskaps opsjonsplan tillater det. Selvfølgelig estimerer formelbaserte eller garantistyrere om kostnaden for ansatteopsjoner er mindre presise enn kontantutbetalinger eller delstilskudd. Men regnskapet bør streve for å være omtrent rett i å reflektere økonomisk virkelighet i stedet for nettopp feil. Ledere stammer rutinemessig på estimater for viktige kostnadsposter, for eksempel avskrivninger på anlegg og utstyr og avsetninger mot ansvarsforpliktelser, som fremtidige miljøopprensninger og bosetninger fra produktansvar og andre rettssaker. Ved beregning av kostnadene for ansattepensjon og andre pensjonsytelser bruker forvaltere aktuarmessige estimater av fremtidige renter, ansettelsespensjon, ansattes pensjonsdato, lengden på arbeidstakerne og deres ektefeller, og økningen av fremtidige medisinske kostnader. Prismodeller og omfattende erfaring gjør det mulig å estimere kostnaden for aksjeopsjoner utstedt i en gitt periode med en presisjon som er sammenlignbar med eller større enn mange av disse andre elementene som allerede vises på selskapsinntekter og balanser. Ikke alle innvendingene mot å bruke Black-Scholes og andre opsjonsvurderingsmodeller er basert på vanskeligheter med å estimere kostnaden for tildelte opsjoner. For eksempel hevdet John DeLong, i et Paper of Competitive Enterprise Institute i juni 2002 med tittelen The Stock Options Controversy og The New Economy, at selv om en verdi ble beregnet ut fra en modell, ville beregningen kreve justering for å gjenspeile verdien til den ansatte. Han er bare halvparten riktig. Ved å betale ansatte med egne aksjer eller opsjoner, tvinger selskapet seg til å holde svært ikke-diversifiserte finansielle porteføljer, en risiko som ytterligere blir kompensert av investeringen av den medarbeiders egen menneskelige kapital i selskapet også. Siden nesten alle enkeltpersoner er risikofylte, kan vi forvente at ansatte skal legge betydelig lavere verdi på deres opsjonspakke enn andre, bedre diversifiserte investorer. Estimater av omfanget av denne risikovurderingsprisen for ansattrisiko, som det noen ganger kalles fra 20 til 50, avhengig av volatiliteten til den underliggende aksjen og graden av diversifisering av medarbeiderporteføljen. Eksistensen av denne dødvektskostnaden brukes noen ganger til å rettferdiggjøre den tilsynelatende store omfanget av opsjonsbasert godtgjørelse utlevert til toppledere. Et selskap som for eksempel søker å belønne sin administrerende direktør med 1 million i opsjoner som er verdt 1000 hver i markedet, kan (kanskje perversivt) på grunn av at det skal utstede 2000 i stedet for 1000 opsjoner fordi opsjonene fra konsernsjefene er mulige bare 500 hver. (Vi vil påpeke at denne begrunnelsen validerer vårt tidligere punkt at alternativene er en erstatning for kontanter.) Men selv om det muligens kan være rimelig å ta hensyn til dødvektskostnad når man bestemmer hvor mye egenkapitalbasert kompensasjon (som opsjoner) skal inkludere i en lederpakke, er det absolutt ikke rimelig å la dødevektskostnader påvirke måten selskapene registrerer kostnadene ved pakkene. Regnskapet reflekterer selskapets økonomiske perspektiv, ikke de enheter (herunder ansatte) som det handler om. Når et selskap selger et produkt til en kunde, for eksempel, trenger det ikke å verifisere hva produktet er verdt for den enkelte. Det teller forventet kontantbetaling i transaksjonen som omsetning. På samme måte, når selskapet kjøper et produkt eller en tjeneste fra en leverandør, undersøker den ikke om den betalte prisen var større eller mindre enn leverandørene kostet eller hva leverandøren kunne ha mottatt dersom det solgte produktet eller tjenesten andre steder. Selskapet registrerer kjøpesummen som kontanter eller kontantekvivalenter den ofrede for å skaffe seg godet eller tjenesten. Anta at en klærprodusent skulle bygge et treningssenter for sine ansatte. Selskapet ville ikke gjøre det for å konkurrere med treningssenter. Det vil bygge senteret for å generere høyere inntekter fra økt produktivitet og kreativitet til sunnere, lykkere ansatte og å redusere kostnader som følge av ansattes omsetning og sykdom. Kostnaden for selskapet er klart kostnaden for å bygge og vedlikeholde anlegget, ikke verdien som de enkelte ansatte kan plassere på den. Kostnaden for treningssenteret er regnskapsført som en periodisk kostnad, løst tilpasset forventet inntektsøkning og reduksjon i ansattes kostnader. Den eneste fornuftige begrunnelsen vi har sett for å koste utøvende opsjoner under markedsverdien, kommer fra observasjonen om at mange opsjoner blir fortapt når ansatte forlater eller blir utøvet for tidlig på grunn av risikovilligheten til ansatte. I disse tilfellene blir eksisterende aksjeeiere fortynnet mindre enn det ellers ville være, eller slet ikke, og dermed redusere selskapets kompensasjonskostnad. Selv om vi er enige med den grunnleggende logikken i dette argumentet, kan virkningen av fortabelse og tidlig utøvelse på teoretiske verdier være grovt overdrevet. (Se den virkelige effekten av fortabelse og tidlig opplæring i slutten av denne artikkelen.) Virkelige konsekvenser av fortabelse og tidlig opplæring I motsetning til kontantlønn, kan opsjoner ikke overføres fra den enkelte tildelt dem til noen andre. Ikke-overførbarhet har to effekter som kombinerer for å gjøre ansattealternativer mindre verdifulle enn konvensjonelle opsjoner som handles i markedet. For det første mister ansatte sine opsjoner dersom de forlater selskapet før opsjonene er opptjent. For det andre har ansatte en tendens til å redusere risikoen ved å utøve interesserte aksjeopsjoner mye tidligere enn en veldiversifisert investor ville, og dermed redusere potensialet for en mye høyere utbytte dersom de hadde opsjonene til forfall. Ansatte med faste opsjoner som er i pengene, vil også utøve dem når de slutter, siden de fleste bedrifter krever at ansatte bruker eller mister sine valg ved avreise. I begge tilfeller reduseres den økonomiske effekten på selskapet ved utstedelse av opsjonene, siden verdien og relative størrelsen på eksisterende aksjeeiersposter blir fortynnet mindre enn de kunne ha vært, eller slet ikke. Å anerkjenne den økende sannsynligheten for at selskapene vil bli pålagt å utnytte aksjeopsjoner, kjemper noen motstandere med en rearguard-handling ved å forsøke å overtale standard settere til å betydelig redusere den rapporterte kostnaden for disse alternativene, diskontere deres verdi fra det som måles av finansielle modeller for å gjenspeile den sterke sannsynlighet for fortabelse og tidlig trening. Nåværende forslag fra disse menneskene til FASB og IASB vil gi selskapene mulighet til å anslå andelen opsjoner som fortabes i løpet av opptjeningsperioden og redusere kostnaden for opsjonsstipendier med dette beløpet. I stedet for å bruke utløpsdatoen for opsjonslivet i en opsjonsprisemodell, søker forslagene å tillate at selskaper bruker et forventet liv for muligheten til å reflektere sannsynligheten for tidlig trening. Ved å bruke et forventet liv (som selskapene kan anslå i nærheten av opptjeningsperioden, si fire år) i stedet for kontraktsperioden på ti år, vil det redusere den estimerte kostnaden av opsjonen betydelig. Noen justeringer bør gjøres for fortabelse og tidlig trening. Men den foreslåtte metoden overstiger betydelig kostnadsreduksjon siden den forsømmer omstendighetene under hvilke opsjoner som mest sannsynlig vil bli fortapt eller utøves tidlig. Når disse omstendighetene er tatt i betraktning, er reduksjonen i ansattskostnadskostnadene sannsynligvis mye mindre. Først vurderer du forfeiture. Å bruke en flat prosentandel for fortabelser basert på historisk eller potensiell ansatt er omsetning kun gyldig dersom fortabelse er en tilfeldig begivenhet, som et lotteri, uavhengig av aksjekursen. I virkeligheten er imidlertid sannsynligheten for fortabelse negativt knyttet til verdien av opsjonsalternativene og dermed til aksjekursen selv. Folk er mer sannsynlig å forlate et selskap og miste opsjoner når aksjekursen har gått ned og alternativene er verdt lite. Men hvis firmaet har gjort det bra og aksjekursen har økt betydelig siden tildelingsdagen, vil alternativene bli mye mer verdifulle, og ansatte vil være mye mindre tilbøyelige til å forlate. Hvis arbeidstakeromsetning og fortabelse er mer sannsynlig når opsjonene er minst verdifulle, reduseres lite av opsjonskostnadene ved tildelingstidspunktet på grunn av sannsynligheten for fortabelse. Argumentet for tidlig trening er lik. Det avhenger også av fremtidig aksjekurs. Ansatte vil ha en tendens til å trene tidlig hvis det meste av deres formue er bundet i selskapet, de må diversifisere, og de har ingen annen måte å redusere risikoeksponeringen mot selskapets aksjekurs. Ledende ansatte, derimot, med de største opsjonsinvesteringene, er usannsynlig å utøve tidlig og ødelegge opsjonsverdien når aksjekursen har steget vesentlig. Ofte har de ubegrenset aksje, som de kan selge som et mer effektivt middel for å redusere risikoeksponeringen. Eller de har nok på plass for å inngå kontrakt med en investeringsbank for å sikre sine opsjonsstillinger uten å utøve for tidlig. Som med fortapningsfunksjonen, vil beregningen av et forventet opsjonsliv uten hensyn til størrelsen på beholdningen av ansatte som trener tidlig, eller til deres evne til å sikre deres risiko på annen måte, betydelig undervurdere kostnaden for opsjoner. Alternativprismodeller kan modifiseres for å inkludere innflytelsen av aksjekursene og omfanget av ansatteopsjoner og aksjebeholdning på sannsynligheten for fortabelse og tidlig trening. (Se for eksempel Mark Rubinsteins Fall 1995 artikkel i Journal of Derivatives. På regnskapsverdi av ansatteaksjonsopsjoner.) Den faktiske størrelsen av disse tilpasningene må baseres på spesifikke bedriftsdata, som aksjekursvekst og distribusjon av opsjonsstipendier blant ansatte. Tilpasningene, som er riktig vurdert, kan vise seg å være betydelig mindre enn de foreslåtte beregningene (tilsynelatende godkjent av FASB og IASB) ville produsere. Faktisk, for noen selskaper, kan en beregning som ignorerer fortabelser og tidlig trening helt kunne komme nærmere den virkelige kostnaden for alternativer enn en som helt ignorerer de faktorene som påvirker ansettelsesforebygging og tidlige treningsbeslutninger. Fallacy 3: Lageropsjonskostnader er allerede tilstrekkelig avslørt Et annet argument til forsvar for den eksisterende tilnærmingen er at selskapene allerede gir opplysninger om kostnaden for opsjonsbevis i fotnoter til regnskapet. Investorer og analytikere som ønsker å justere resultatregnskapet for kostnaden av opsjoner, har derfor de nødvendige dataene lett tilgjengelige. Vi finner det argumentet vanskelig å svelge. Som vi har påpekt, er det et grunnleggende regnskapsprinsipp at resultatregnskapet og balansen skal skildre selskapets underliggende økonomi. Hvis man fjerner et element av så stor økonomisk betydning som ansattes opsjonsstipend til fotnoter, vil dette systematisk forvride disse rapportene. Men selv om vi skulle akseptere prinsippet om at opplysning av fotnote er tilstrekkelig, ville vi i virkeligheten finne det en dårlig erstatning for å regne ut regningen direkte på de primære uttalelsene. For å begynne med bruker investeringsanalytikere, advokater og tilsynsmyndigheter nå elektroniske databaser for å beregne lønnsomhetsforhold basert på tallene i selskapene reviderte resultatregnskap og balanser. En analytiker som følger et enkelt selskap, eller til og med en liten gruppe selskaper, kan gjøre justeringer for informasjon som er beskrevet i fotnoter. Men det ville være vanskelig og kostbart å gjøre for en stor gruppe selskaper som hadde satt forskjellige typer data i ulike ikke-standardformater i fotnoter. Det er klart at det er mye lettere å sammenligne selskaper på like vilkår, hvor alle kompensasjonskostnader er innarbeidet i inntektsnumrene. Hva mer, tallene som er oppgitt i fotnoter, kan være mindre pålitelige enn de som er beskrevet i hovedregnskapet. For det første vurderer ledere og revisorer vanligvis tilleggsfotnoter sist og bruker mindre tid til dem enn de gjør til tallene i de primære uttalelsene. Som et eksempel viser fotnoten i eBays FY 2000 årsrapport en veid gjennomsnittlig tildelingstidsmessig verdi på opsjoner gitt i 1999 på 105,03 i et år hvor den veide gjennomsnittlige utøvelseskursen på aksjer ble 64,59. Bare hvordan verdien av tildelte opsjoner kan være 63 mer enn verdien av den underliggende aksjen er ikke åpenbar. I 2000 ble samme effekt rapportert: en virkelig verdi på opsjoner gitt av 103,79 med en gjennomsnittlig utøvelseskurs på 62,69. Tilsynelatende ble denne feilen endelig oppdaget, siden rapporten fra FY 2001 med tilbakevendende tilpasning av gjennomsnittlige dagverdier for 1999 og 2000 til henholdsvis 40,45 og 41,40. Vi tror at ledere og revisorer vil utøve større omhu og omsorg for å skaffe pålitelige estimater av kostnaden ved aksjeopsjoner dersom disse tallene er inkludert i selskapsresultatregnskapene enn de for øyeblikket gjør for fotnotebeskrivelse. Vår kollega William Sahlman i sin HBR-artikkel i desember 2002, Utgiftsløsninger løser ingenting, har uttrykt bekymring for at rikdom av nyttig informasjon i fotnoteene om aksjeopsjoner som er gitt, vil gå tapt hvis opsjonene kostnadsføres. Men å anerkjenne kostnaden for opsjoner i resultatregnskapet utelukker ikke at man fortsetter å gi en fotnote som forklarer den underliggende fordelingen av tilskudd og metodologien og parameterinngangene som brukes til å beregne kostnaden for aksjeopsjonene. Noen kritikere av opsjonsutgiften argumenterer, som venturekapitalist John Doerr og FedEx CEO Frederick Smith gjorde i en kolonne i New York Times den 5. april 2002 at hvis kostnadene skulle kreves, ble virkningen av opsjoner talt to ganger i resultat per aksje : Først som en potensiell fortynning av inntjeningen, ved å øke utestående aksjer, og andre som avgift mot rapportert inntjening. Resultatet ville være unøyaktig og villedende inntjening per aksje. Vi har flere problemer med dette argumentet. For det første utgjør opsjonskostnadene bare en (GAAP-basert) utvannet resultat per aksjeberegning når dagens markedspris overstiger opsjonsutnyttelseskursen. Således ignorerer fullt utvannede EPS-numre all kostnaden for opsjoner som er nesten i pengene, eller kan bli i pengene dersom aksjekursen økte betydelig i nær fremtid. Second, relegating the determination of the economic impact of stock option grants solely to an EPS calculation greatly distorts the measurement of reported income, would not be adjusted to reflect the economic impact of option costs. These measures are more significant summaries of the change in economic value of a company than the prorated distribution of this income to individual shareholders revealed in the EPS measure. This becomes eminently clear when taken to its logical absurdity: Suppose companies were to compensate all their suppliersof materials, labor, energy, and purchased serviceswith stock options rather than with cash and avoid all expense recognition in their income statement. Their income and their profitability measures would all be so grossly inflated as to be useless for analytic purposes only the EPS number would pick up any economic effect from the option grants. Our biggest objection to this spurious claim, however, is that even a calculation of fully diluted EPS does not fully reflect the economic impact of stock option grants. The following hypothetical example illustrates the problems, though for purposes of simplicity we will use grants of shares instead of options. The reasoning is exactly the same for both cases. Lets say that each of our two hypothetical companies, KapCorp and MerBod, has 8,000 shares outstanding, no debt, and annual revenue this year of 100,000. KapCorp decides to pay its employees and suppliers 90,000 in cash and has no other expenses. MerBod, however, compensates its employees and suppliers with 80,000 in cash and 2,000 shares of stock, at an average market price of 5 per share. The cost to each company is the same: 90,000. But their net income and EPS numbers are very different. KapCorps net income before taxes is 10,000, or 1.25 per share. By contrast, MerBods reported net income (which ignores the cost of the equity granted to employees and suppliers) is 20,000, and its EPS is 2.00 (which takes into account the new shares issued). Of course, the two companies now have different cash balances and numbers of shares outstanding with a claim on them. But KapCorp can eliminate that discrepancy by issuing 2,000 shares of stock in the market during the year at an average selling price of 5 per share. Now both companies have closing cash balances of 20,000 and 10,000 shares outstanding. Under current accounting rules, however, this transaction only exacerbates the gap between the EPS numbers. KapCorps reported income remains 10,000, since the additional 10,000 value gained from the sale of the shares is not reported in net income, but its EPS denominator has increased from 8,000 to 10,000. Consequently, KapCorp now reports an EPS of 1.00 to MerBods 2.00, even though their economic positions are identical: 10,000 shares outstanding and increased cash balances of 20,000. The people claiming that options expensing creates a double-counting problem are themselves creating a smoke screen to hide the income-distorting effects of stock option grants. The people claiming that options expensing creates a double-counting problem are themselves creating a smoke screen to hide the income-distorting effects of stock option grants. Indeed, if we say that the fully diluted EPS figure is the right way to disclose the impact of share options, then we should immediately change the current accounting rules for situations when companies issue common stock, convertible preferred stock, or convertible bonds to pay for services or assets. At present, when these transactions occur, the cost is measured by the fair market value of the consideration involved. Why should options be treated differently Fallacy 4: Expensing Stock Options Will Hurt Young Businesses Opponents of expensing options also claim that doing so will be a hardship for entrepreneurial high-tech firms that do not have the cash to attract and retain the engineers and executives who translate entrepreneurial ideas into profitable, long-term growth. This argument is flawed on a number of levels. For a start, the people who claim that option expensing will harm entrepreneurial incentives are often the same people who claim that current disclosure is adequate for communicating the economics of stock option grants. The two positions are clearly contradictory. If current disclosure is sufficient, then moving the cost from a footnote to the balance sheet and income statement will have no market effect. But to argue that proper costing of stock options would have a significant adverse impact on companies that make extensive use of them is to admit that the economics of stock options, as currently disclosed in footnotes, are not fully reflected in companies market prices. More seriously, however, the claim simply ignores the fact that a lack of cash need not be a barrier to compensating executives. Rather than issuing options directly to employees, companies can always issue them to underwriters and then pay their employees out of the money received for those options. Considering that the market systematically puts a higher value on options than employees do, companies are likely to end up with more cash from the sale of externally issued options (which carry with them no deadweight costs) than they would by granting options to employees in lieu of higher salaries. Even privately held companies that raise funds through angel and venture capital investors can take this approach. The same procedures used to place a value on a privately held company can be used to estimate the value of its options, enabling external investors to provide cash for options about as readily as they provide cash for stock. Thats not to say, of course, that entrepreneurs should never get option grants. Venture capital investors will always want employees to be compensated with some stock options in lieu of cash to be assured that the employees have some skin in the game and so are more likely to be honest when they tout their companys prospects to providers of new capital. But that does not preclude also raising cash by selling options externally to pay a large part of the cash compensation to employees. We certainly recognize the vitality and wealth that entrepreneurial ventures, particularly those in the high-tech sector, bring to the U. S. economy. A strong case can be made for creating public policies that actively assist these companies in their early stages, or even in their more established stages. The nation should definitely consider a regulation that makes entrepreneurial, job-creating companies healthier and more competitive by changing something as simple as an accounting journal entry. But we have to question the effectiveness of the current rule, which essentially makes the benefits from a deliberate accounting distortion proportional to companies use of one particular form of employee compensation. After all, some entrepreneurial, job-creating companies might benefit from picking other forms of incentive compensation that arguably do a better job of aligning executive and shareholder interests than conventional stock options do. Indexed or performance options, for example, ensure that management is not rewarded just for being in the right place at the right time or penalized just for being in the wrong place at the wrong time. A strong case can also be made for the superiority of properly designed restricted stock grants and deferred cash payments. Yet current accounting standards require that these, and virtually all other compensation alternatives, be expensed. Are companies that choose those alternatives any less deserving of an accounting subsidy than Microsoft, which, having granted 300 million options in 2001 alone, is by far the largest issuer of stock options A less distorting approach for delivering an accounting subsidy to entrepreneurial ventures would simply be to allow them to defer some percentage of their total employee compensation for some number of years, which could be indefinitelyjust as companies granting stock options do now. That way, companies could get the supposed accounting benefits from not having to report a portion of their compensation costs no matter what form that compensation might take. What Will Expensing Involve Although the economic arguments in favor of reporting stock option grants on the principal financial statements seem to us to be overwhelming, we do recognize that expensing poses challenges. For a start, the benefits accruing to the company from issuing stock options occur in future periods, in the form of increased cash flows generated by its option motivated and retained employees. The fundamental matching principle of accounting requires that the costs of generating those higher revenues be recognized at the same time the revenues are recorded. This is why companies match the cost of multiperiod assets such as plant and equipment with the revenues these assets produce over their economic lives. In some cases, the match can be based on estimates of the future cash flows. In expensing capitalized software-development costs, for instance, managers match the costs against a predicted pattern of benefits accrued from selling the software. In the case of options, however, managers would have to estimate an equivalent pattern of benefits arising from their own decisions and activities. That would likely introduce significant measurement error and provide opportunities for managers to bias their estimates. We therefore believe that using a standard straight-line amortization formula will reduce measurement error and management bias despite some loss of accuracy. The obvious period for the amortization is the useful economic life of the granted option, probably best measured by the vesting period. Thus, for an option vesting in four years, 148 of the cost of the option would be expensed through the income statement in each month until the option vests. This would treat employee option compensation costs the same way the costs of plant and equipment or inventory are treated when they are acquired through equity instruments, such as in an acquisition. In addition to being reported on the income statement, the option grant should also appear on the balance sheet. In our opinion, the cost of options issued represents an increase in shareholders equity at the time of grant and should be reported as paid-in capital. Some experts argue that stock options are more like contingent liability than equity transactions since their ultimate cost to the company cannot be determined until employees either exercise or forfeit their options. This argument, of course, ignores the considerable economic value the company has sacrificed at time of grant. Whats more, a contingent liability is usually recognized as an expense when it is possible to estimate its value and the liability is likely to be incurred. At time of grant, both these conditions are met. The value transfer is not just probable it is certain. The company has granted employees an equity security that could have been issued to investors and suppliers who would have given cash, goods, and services in return. The amount sacrificed can also be estimated, using option-pricing models or independent estimates from investment banks. There has to be, of course, an offsetting entry on the asset side of the balance sheet. FASB, in its exposure draft on stock option accounting in 1994, proposed that at time of grant an asset called prepaid compensation expense be recognized, a recommendation we endorse. FASB, however, subsequently retracted its proposal in the face of criticism that since employees can quit at any time, treating their deferred compensation as an asset would violate the principle that a company must always have legal control over the assets it reports. We feel that FASB capitulated too easily to this argument. The firm does have an asset because of the option grantpresumably a loyal, motivated employee. Even though the firm does not control the asset in a legal sense, it does capture the benefits. FASBs concession on this issue subverted substance to form. Finally, there is the issue of whether to allow companies to revise the income number theyve reported after the grants have been issued. Some commentators argue that any recorded stock option compensation expense should be reversed if employees forfeit the options by leaving the company before vesting or if their options expire unexercised. But if companies were to mark compensation expense downward when employees forfeit their options, should they not also mark it up when the share price rises, thereby increasing the market value of the options Clearly, this can get complicated, and it comes as no surprise that neither FASB nor IASB recommends any kind of postgrant accounting revisions, since that would open up the question of whether to use mark-to-market accounting for all types of assets and liabilities, not just share options. At this time, we dont have strong feelings about whether the benefits from mark-to-market accounting for stock options exceed the costs. But we would point out that people who object to estimating the cost of options granted at time of issue should be even less enthusiastic about reestimating their options cost each quarter. We recognize that options are a powerful incentive, and we believe that all companies should consider them in deciding how to attract and retain talent and align the interests of managers and owners. But we also believe that failing to record a transaction that creates such powerful effects is economically indefensible and encourages companies to favor options over alternative compensation methods. It is not the proper role of accounting standards to distort executive and employee compensation by subsidizing one form of compensation relative to all others. Companies should choose compensation methods according to their economic benefitsnot the way they are reported. It is not the proper role of accounting standards to distort executive and employee compensation by subsidizing one form of compensation relative to all others. A version of this article appeared in the March 2003 issue of Harvard Business Review. Accounting for Employee Stock Option Plan ESOP Securities and Exchange Board of India issued ESOP guidelines in 1999. The idea behind this was to reward and motivate employees for their commitment and hard work. SEBI defines employee stock options as option given to the whole-time directors, officers or employees of a company which gives such Directors, officers or employees, the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a predetermined price. Before we go in the detail of ESOP accounting let us understand a few terms. Vesting means the process by which the employee gets the right to apply for and be issued Shares of the company under the options granted to him. Vesting period means the period over which the vesting of the options of the employee Takes place Exercise period means the time period after vesting within which the employee should Exercise his right to buy the shares by payment of the option price on the options vested in Him. If the exercise period lapses the vested option lapses and no right shall accrue to the Employee thereafter The act of exercise implies an application being made by the employee to the company to Have the options vested in him issued as shares upon payment of the option price. Exercise can take place as specified after vesting The trust route is often adopted to route the ESOS scheme. It works like this: a company creates a trust for the employees and the trust receives its stock either by fresh allotment or by purchase from shareholders or the owner may sell shares of his holding to the trust. The trust obtains its finds through loans and allots shares to employees on exercise of their right in exchange for cash and repays its loans. These Guidelines applies to any company whose shares are listed on any stock exchange in India and came into force with immediate effect from 19 th of June 1999. The stock exchanges were advised that the shares issued pursuant to ESOP would be eligible for listing only if such instruments were in accordance with these Guidelines. In respect of options granted during any Accounting period, the Accounting value of the options shall be treated as another form of employee compensation in the financial statements of the company. The Accounting value of options shall be equal to the maximum of: a) The aggregate over all employee stock options granted during any Accounting period of the excess of the fair value of the option over the specified percentage of the market value of the share on the date of grant of the option or b) Excess of the aggregate of the option discounts on all employee stock options granted during any Accounting period over 20 of the total employee compensation as reported in the profit and loss account of that period. For this purpose: 1. Fair value means the option discount, or, if the company so chooses, the value of the option using the Black Scholes formula or other similar valuation method. 2. Option discount means the excess of the market price of the share at the time of grant of the option over the exercise price of the option (including up-front payment if any) 3. Specified percentage means 25 in case of options granted within 12 months of the effective date, 20 in case of options granted during the 13 to 24 months after the effective date, and 15 in case of options granted after 24 months of the effective date. Effective date is the date on which these guidelines come into effect. Where the Accounting value is accounted for as employee compensation in accordance with the above stated. the amount should be amortized on a straight-line basis over the vesting period. When an unvested employee stock option lapses by virtue of the employee not conforming to the vesting conditions after the Accounting value of the option has already been accounted for as employee compensation, this Accounting treatment shall be reversed by a credit to employee compensation expense equal to the amortized portion of the Accounting value of the lapsed options and a credit to deferred employee compensation expense equal to the unamortized portion. When a vested employee stock option lapses on expiry of the exercise period, after the Accounting value of the option has already been accounted for as employee compensation, this Accounting treatment shall be reversed by a credit to employee compensation expense. The Accounting treatment prescribed above can be illustrated by the following numerical example. Suppose a company grants 500 options on 141999 at Rs 40 when the market price is Rs 160, the vesting period is two and a half years, the maximum exercise period is one year and the total employee compensation for the year 1999- 2000 is Rs 900,000. Also supposed that 150 unvested options lapse on 152001, 300 options are exercised on 3062002 and 50 vested options lapse at the end of the exercise period. The Accounting value of the option being the maximum of: a) 500 x (160-40) - 25 x 160 500 x 120 - 40 500 x 80 40,000 b) 500 x (160-40) - 10 x 900,000 60,000 - 90,000 -30,000 would be equal to Rs 40,000. The Accounting entries would be as follows: 141999 Deferred Employee Compensation Expense 40,000 Employee Stock Options Outstanding 40,000 (Grant of 500 options at an Accounting value of Rs 80 each) 3132000 Employee Compensation Expense 16,000 Deferred Employee Compensation Expense 16,000 (Amortisation of the deferred compensation over two and a half years on straight-line basis) 3132001 Employee Compensation Expense 16,000 Deferred Employee Compensation Expense 16,000 (Amortisation of the deferred compensation over two and a half years on straight-line basis) 152001 Employee Stock Options Outstanding 12,000 Employee Compensation Expense 9,600 Deferred Employee Compensation Expense 2,400 (Reversal of compensation Accounting on lapse of 150 unvested options) 3132002 Employee Compensation Expense 5,600 Deferred Employee Compensation Expense 5,600 (Amortisation of the deferred compensation over two and a half years on straight-line basis) 3062002 Cash 12,000 Employee Stock Options Outstan ding 24,000 Paid Up Equity Capital 3,000 Share Premium Account 33,000 (Exercise of 300 options at an exercise price of Rs 40 each and an Accounting value of Rs 80 each) 1102002 Employee Stock Options Outstanding 4,000 Employee Compensation Expense 4,000 (Reversal of compensation Accounting on lapse of 50 vested options at end of exercise period) Employee stock option outstanding will appear in the Balance Sheet as part of net worth or share holders equity. Deferred employee compensation will appear in the Balance Sheet as a negative item as part of net worth or share holders equity. Disclosure in Directors Report The Board of Directors shall disclose either in the Directors Report or in the annexure to the Directors Report, the following details of the Stock option plan: a) The total number of shares covered by the Employee Stock Option scheme as approved by the shareholders b) The Pricing formula c) Options granted d) Options vested e) Options exercised f) Options forfeited g) Extinguishment or modification of options h) Money realised by exercise of options i) Total number of options in force j) Employee wise details of options granted to i) Senior managerial personnel nnnnii) any other employee who receives a grant in any one year of options amounting to 5 or more of options granted during that year. k) Diluted Earnings Per Share (EPS) calculated in accordance with International Accounting Standard (IAS) In todays world ESOPs have been increasingly used as a motivating weapon by the management to retain its most efficient employees. Employees of blue chip companies like Infosys, Wipro, ITC and others become millionaires overnight. But the tool meant for rewarding employees commitment is being misused by few senior managers to serve their self-interest by manipulating the market price. Some investors are unhappy with the scheme as it dilutes their level of participation in companys affairs. Also the very purpose of ESOPs will get defeated if the employees sell their shares in the market. The scheme also has an uncertainty hidden due to the fluctuating stock prices. Despite the disadvantages ESOPs is still a popular tool to attract and retain the best talent and hence the management must draw a scheme suiting the employees expectations and must study the dynamic changes in stock market to ensure its success. For the Last Time: Stock Options Are an Expense The time has come to end the debate on accounting for stock options the controversy has been going on far too long. In fact, the rule governing the reporting of executive stock options dates back to 1972, when the Accounting Principles Board, the predecessor to the Financial Accounting Standards Board (FASB), issued APB 25. The rule specified that the cost of options at the grant date should be measured by their intrinsic valuethe difference between the current fair market value of the stock and the exercise price of the option. Under this method, no cost was assigned to options when their exercise price was set at the current market price. The rationale for the rule was fairly simple: Because no cash changes hands when the grant is made, issuing a stock option is not an economically significant transaction. Thats what many thought at the time. Whats more, little theory or practice was available in 1972 to guide companies in determining the value of such untraded financial instruments. APB 25 was obsolete within a year. The publication in 1973 of the Black-Scholes formula triggered a huge boom in markets for publicly traded options, a movement reinforced by the opening, also in 1973, of the Chicago Board Options Exchange. It was surely no coincidence that the growth of the traded options markets was mirrored by an increasing use of share option grants in executive and employee compensation. The National Center for Employee Ownership estimates that nearly 10 million employees received stock options in 2000 fewer than 1 million did in 1990. It soon became clear in both theory and practice that options of any kind were worth far more than the intrinsic value defined by APB 25. FASB initiated a review of stock option accounting in 1984 and, after more than a decade of heated controversy, finally issued SFAS 123 in October 1995. It recommendedbut did not requirecompanies to report the cost of options granted and to determine their fair market value using option-pricing models. The new standard was a compromise, reflecting intense lobbying by businesspeople and politicians against mandatory reporting. They argued that executive stock options were one of the defining components in Americas extraordinary economic renaissance, so any attempt to change the accounting rules for them was an attack on Americas hugely successful model for creating new businesses. Inevitably, most companies chose to ignore the recommendation that they opposed so vehemently and continued to record only the intrinsic value at grant date, typically zero, of their stock option grants. Subsequently, the extraordinary boom in share prices made critics of option expensing look like spoilsports. But since the crash, the debate has returned with a vengeance. The spate of corporate accounting scandals in particular has revealed just how unreal a picture of their economic performance many companies have been painting in their financial statements. Increasingly, investors and regulators have come to recognize that option-based compensation is a major distorting factor. Had AOL Time Warner in 2001, for example, reported employee stock option expenses as recommended by SFAS 123, it would have shown an operating loss of about 1.7 billion rather than the 700 million in operating income it actually reported. We believe that the case for expensing options is overwhelming, and in the following pages we examine and dismiss the principal claims put forward by those who continue to oppose it. We demonstrate that, contrary to these experts arguments, stock option grants have real cash-flow implications that need to be reported, that the way to quantify those implications is available, that footnote disclosure is not an acceptable substitute for reporting the transaction in the income statement and balance sheet, and that full recognition of option costs need not emasculate the incentives of entrepreneurial ventures. We then discuss just how firms might go about reporting the cost of options on their income statements and balance sheets. Fallacy 1: Stock Options Do Not Represent a Real Cost It is a basic principle of accounting that financial statements should record economically significant transactions. No one doubts that traded options meet that criterion billions of dollars worth are bought and sold every day, either in the over-the-counter market or on exchanges. For many people, though, company stock option grants are a different story. These transactions are not economically significant, the argument goes, because no cash changes hands. As former American Express CEO Harvey Golub put it in an August 8, 2002, Wall Street Journal article, stock option grants are never a cost to the company and, therefore, should never be recorded as a cost on the income statement. That position defies economic logic, not to mention common sense, in several respects. For a start, transfers of value do not have to involve transfers of cash. While a transaction involving a cash receipt or payment is sufficient to generate a recordable transaction, it is not necessary. Events such as exchanging stock for assets, signing a lease, providing future pension or vacation benefits for current-period employment, or acquiring materials on credit all trigger accounting transactions because they involve transfers of value, even though no cash changes hands at the time the transaction occurs. Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost, which needs to be accounted for. If a company were to grant stock, rather than options, to employees, everyone would agree that the companys cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors. It is exactly the same with stock options. When a company grants options to employees, it forgoes the opportunity to receive cash from underwriters who could take these same options and sell them in a competitive options market to investors. Warren Buffett made this point graphically in an April 9, 2002, Washington Post column when he stated: Berkshire Hathaway will be happy to receive options in lieu of cash for many of the goods and services that we sell corporate America. Granting options to employees rather than selling them to suppliers or investors via underwriters involves an actual loss of cash to the firm. It can, of course, be more reasonably argued that the cash forgone by issuing options to employees, rather than selling them to investors, is offset by the cash the company conserves by paying its employees less cash. As two widely respected economists, Burton G. Malkiel and William J. Baumol, noted in an April 4, 2002, Wall Street Journal article: A new, entrepreneurial firm may not be able to provide the cash compensation needed to attract outstanding workers. Instead, it can offer stock options. But Malkiel and Baumol, unfortunately, do not follow their observation to its logical conclusion. For if the cost of stock options is not universally incorporated into the measurement of net income, companies that grant options will underreport compensation costs, and it wont be possible to compare their profitability, productivity, and return-on-capital measures with those of economically equivalent companies that have merely structured their compensation system in a different way. The following hypothetical illustration shows how that can happen. Imagine two companies, KapCorp and MerBod, competing in exactly the same line of business. The two differ only in the structure of their employee compensation packages. KapCorp pays its workers 400,000 in total compensation in the form of cash during the year. At the beginning of the year, it also issues, through an underwriting, 100,000 worth of options in the capital market, which cannot be exercised for one year, and it requires its employees to use 25 of their compensation to buy the newly issued options. The net cash outflow to KapCorp is 300,000 (400,000 in compensation expense less 100,000 from the sale of the options). MerBods approach is only slightly different. It pays its workers 300,000 in cash and issues them directly 100,000 worth of options at the start of the year (with the same one-year exercise restriction). Economically, the two positions are identical. Each company has paid a total of 400,000 in compensation, each has issued 100,000 worth of options, and for each the net cash outflow totals 300,000 after the cash received from issuing the options is subtracted from the cash spent on compensation. Employees at both companies are holding the same 100,000 of options during the year, producing the same motivation, incentive, and retention effects. How legitimate is an accounting standard that allows two economically identical transactions to produce radically different numbers In preparing its year-end statements, KapCorp will book compensation expense of 400,000 and will show 100,000 in options on its balance sheet in a shareholder equity account. If the cost of stock options issued to employees is not recognized as an expense, however, MerBod will book a compensation expense of only 300,000 and not show any options issued on its balance sheet. Assuming otherwise identical revenues and costs, it will look as though MerBods earnings were 100,000 higher than KapCorps. MerBod will also seem to have a lower equity base than KapCorp, even though the increase in the number of shares outstanding will eventually be the same for both companies if all the options are exercised. As a result of the lower compensation expense and lower equity position, MerBods performance by most analytic measures will appear to be far superior to KapCorps. This distortion is, of course, repeated every year that the two firms choose the different forms of compensation. How legitimate is an accounting standard that allows two economically identical transactions to produce radically different numbers Fallacy 2: The Cost of Employee Stock Options Cannot Be Estimated Some opponents of option expensing defend their position on practical, not conceptual, grounds. Option-pricing models may work, they say, as a guide for valuing publicly traded options. But they cant capture the value of employee stock options, which are private contracts between the company and the employee for illiquid instruments that cannot be freely sold, swapped, pledged as collateral, or hedged. It is indeed true that, in general, an instruments lack of liquidity will reduce its value to the holder. But the holders liquidity loss makes no difference to what it costs the issuer to create the instrument unless the issuer somehow benefits from the lack of liquidity. And for stock options, the absence of a liquid market has little effect on their value to the holder. The great beauty of option-pricing models is that they are based on the characteristics of the underlying stock. Thats precisely why they have contributed to the extraordinary growth of options markets over the last 30 years. The Black-Scholes price of an option equals the value of a portfolio of stock and cash that is managed dynamically to replicate the payoffs to that option. With a completely liquid stock, an otherwise unconstrained investor could entirely hedge an options risk and extract its value by selling short the replicating portfolio of stock and cash. In that case, the liquidity discount on the options value would be minimal. And that applies even if there were no market for trading the option directly. Therefore, the liquidityor lack thereofof markets in stock options does not, by itself, lead to a discount in the options value to the holder. Investment banks, commercial banks, and insurance companies have now gone far beyond the basic, 30-year-old Black-Scholes model to develop approaches to pricing all sorts of options: Standard ones. Exotic ones. Options traded through intermediaries, over the counter, and on exchanges. Options linked to currency fluctuations. Options embedded in complex securities such as convertible debt, preferred stock, or callable debt like mortgages with prepay features or interest rate caps and floors. A whole subindustry has developed to help individuals, companies, and money market managers buy and sell these complex securities. Current financial technology certainly permits firms to incorporate all the features of employee stock options into a pricing model. A few investment banks will even quote prices for executives looking to hedge or sell their stock options prior to vesting, if their companys option plan allows it. Of course, formula-based or underwriters estimates about the cost of employee stock options are less precise than cash payouts or share grants. But financial statements should strive to be approximately right in reflecting economic reality rather than precisely wrong. Managers routinely rely on estimates for important cost items, such as the depreciation of plant and equipment and provisions against contingent liabilities, such as future environmental cleanups and settlements from product liability suits and other litigation. When calculating the costs of employees pensions and other retirement benefits, for instance, managers use actuarial estimates of future interest rates, employee retention rates, employee retirement dates, the longevity of employees and their spouses, and the escalation of future medical costs. Pricing models and extensive experience make it possible to estimate the cost of stock options issued in any given period with a precision comparable to, or greater than, many of these other items that already appear on companies income statements and balance sheets. Not all the objections to using Black-Scholes and other option valuation models are based on difficulties in estimating the cost of options granted. For example, John DeLong, in a June 2002 Competitive Enterprise Institute paper entitled The Stock Options Controversy and the New Economy, argued that even if a value were calculated according to a model, the calculation would require adjustment to reflect the value to the employee. He is only half right. By paying employees with its own stock or options, the company forces them to hold highly non-diversified financial portfolios, a risk further compounded by the investment of the employees own human capital in the company as well. Since almost all individuals are risk averse, we can expect employees to place substantially less value on their stock option package than other, better-diversified, investors would. Estimates of the magnitude of this employee risk discountor deadweight cost, as it is sometimes calledrange from 20 to 50, depending on the volatility of the underlying stock and the degree of diversification of the employees portfolio. The existence of this deadweight cost is sometimes used to justify the apparently huge scale of option-based remuneration handed out to top executives. A company seeking, for instance, to reward its CEO with 1 million in options that are worth 1,000 each in the market may (perhaps perversely) reason that it should issue 2,000 rather than 1,000 options because, from the CEOs perspective, the options are worth only 500 each. (We would point out that this reasoning validates our earlier point that options are a substitute for cash.) But while it might arguably be reasonable to take deadweight cost into account when deciding how much equity-based compensation (such as options) to include in an executives pay packet, it is certainly not reasonable to let dead-weight cost influence the way companies record the costs of the packets. Financial statements reflect the economic perspective of the company, not the entities (including employees) with which it transacts. When a company sells a product to a customer, for example, it does not have to verify what the product is worth to that individual. It counts the expected cash payment in the transaction as its revenue. Similarly, when the company purchases a product or service from a supplier, it does not examine whether the price paid was greater or less than the suppliers cost or what the supplier could have received had it sold the product or service elsewhere. The company records the purchase price as the cash or cash equivalent it sacrificed to acquire the good or service. Suppose a clothing manufacturer were to build a fitness center for its employees. The company would not do so to compete with fitness clubs. It would build the center to generate higher revenues from increased productivity and creativity of healthier, happier employees and to reduce costs arising from employee turnover and illness. The cost to the company is clearly the cost of building and maintaining the facility, not the value that the individual employees might place on it. The cost of the fitness center is recorded as a periodic expense, loosely matched to the expected revenue increase and reductions in employee-related costs. The only reasonable justification we have seen for costing executive options below their market value stems from the observation that many options are forfeited when employees leave, or are exercised too early because of employees risk aversion. In these cases, existing shareholders equity is diluted less than it would otherwise be, or not at all, consequently reducing the companys compensation cost. While we agree with the basic logic of this argument, the impact of forfeiture and early exercise on theoretical values may be grossly exaggerated. (See The Real Impact of Forfeiture and Early Exercise at the end of this article.) The Real Impact of Forfeiture and Early Exercise Unlike cash salary, stock options cannot be transferred from the individual granted them to anyone else. Nontransferability has two effects that combine to make employee options less valuable than conventional options traded in the market. First, employees forfeit their options if they leave the company before the options have vested. Second, employees tend to reduce their risk by exercising vested stock options much earlier than a well-diversified investor would, thereby reducing the potential for a much higher payoff had they held the options to maturity. Employees with vested options that are in the money will also exercise them when they quit, since most companies require employees to use or lose their options upon departure. In both cases, the economic impact on the company of issuing the options is reduced, since the value and relative size of existing shareholders stakes are diluted less than they could have been, or not at all. Recognizing the increasing probability that companies will be required to expense stock options, some opponents are fighting a rearguard action by trying to persuade standard setters to significantly reduce the reported cost of those options, discounting their value from that measured by financial models to reflect the strong likelihood of forfeiture and early exercise. Current proposals put forth by these people to FASB and IASB would allow companies to estimate the percentage of options forfeited during the vesting period and reduce the cost of option grants by this amount. Also, rather than use the expiration date for the option life in an option-pricing model, the proposals seek to allow companies to use an expected life for the option to reflect the likelihood of early exercise. Using an expected life (which companies may estimate at close to the vesting period, say, four years) instead of the contractual period of, say, ten years, would significantly reduce the estimated cost of the option. Some adjustment should be made for forfeiture and early exercise. But the proposed method significantly overstates the cost reduction since it neglects the circumstances under which options are most likely to be forfeited or exercised early. When these circumstances are taken into account, the reduction in employee option costs is likely to be much smaller. First, consider forfeiture. Using a flat percentage for forfeitures based on historical or prospective employee turnover is valid only if forfeiture is a random event, like a lottery, independent of the stock price. In reality, however, the likelihood of forfeiture is negatively related to the value of the options forfeited and, hence, to the stock price itself. People are more likely to leave a company and forfeit options when the stock price has declined and the options are worth little. But if the firm has done well and the stock price has increased significantly since grant date, the options will have become much more valuable, and employees will be much less likely to leave. If employee turnover and forfeiture are more likely when the options are least valuable, then little of the options total cost at grant date is reduced because of the probability of forfeiture. The argument for early exercise is similar. It also depends on the future stock price. Employees will tend to exercise early if most of their wealth is bound up in the company, they need to diversify, and they have no other way to reduce their risk exposure to the companys stock price. Senior executives, however, with the largest option holdings, are unlikely to exercise early and destroy option value when the stock price has risen substantially. Often they own unrestricted stock, which they can sell as a more efficient means to reduce their risk exposure. Or they have enough at stake to contract with an investment bank to hedge their option positions without exercising prematurely. As with the forfeiture feature, the calculation of an expected option life without regard to the magnitude of the holdings of employees who exercise early, or to their ability to hedge their risk through other means, would significantly underestimate the cost of options granted. Option-pricing models can be modified to incorporate the influence of stock prices and the magnitude of employees option and stock holdings on the probabilities of forfeiture and early exercise. (See, for example, Mark Rubinsteins Fall 1995 article in the Journal of Derivatives . On the Accounting Valuation of Employee Stock Options.) The actual magnitude of these adjustments needs to be based on specific company data, such as stock price appreciation and distribution of option grants among employees. The adjustments, properly assessed, could turn out to be significantly smaller than the proposed calculations (apparently endorsed by FASB and IASB) would produce. Indeed, for some companies, a calculation that ignores forfeiture and early exercise altogether could come closer to the true cost of options than one that entirely ignores the factors that influence employees forfeiture and early exercise decisions. Fallacy 3: Stock Option Costs Are Already Adequately Disclosed Another argument in defense of the existing approach is that companies already disclose information about the cost of option grants in the footnotes to the financial statements. Investors and analysts who wish to adjust income statements for the cost of options, therefore, have the necessary data readily available. We find that argument hard to swallow. As we have pointed out, it is a fundamental principle of accounting that the income statement and balance sheet should portray a companys underlying economics. Relegating an item of such major economic significance as employee option grants to the footnotes would systematically distort those reports. But even if we were to accept the principle that footnote disclosure is sufficient, in reality we would find it a poor substitute for recognizing the expense directly on the primary statements. For a start, investment analysts, lawyers, and regulators now use electronic databases to calculate profitability ratios based on the numbers in companies audited income statements and balance sheets. An analyst following an individual company, or even a small group of companies, could make adjustments for information disclosed in footnotes. But that would be difficult and costly to do for a large group of companies that had put different sorts of data in various nonstandard formats into footnotes. Clearly, it is much easier to compare companies on a level playing field, where all compensation expenses have been incorporated into the income numbers. Whats more, numbers divulged in footnotes can be less reliable than those disclosed in the primary financial statements. For one thing, executives and auditors typically review supplementary footnotes last and devote less time to them than they do to the numbers in the primary statements. As just one example, the footnote in eBays FY 2000 annual report reveals a weighted average grant-date fair value of options granted during 1999 of 105.03 for a year in which the weighted average exercise price of shares granted was 64.59. Just how the value of options granted can be 63 more than the value of the underlying stock is not obvious. In FY 2000, the same effect was reported: a fair value of options granted of 103.79 with an average exercise price of 62.69. Apparently, this error was finally detected, since the FY 2001 report retroactively adjusted the 1999 and 2000 average grant-date fair values to 40.45 and 41.40, respectively. We believe executives and auditors will exert greater diligence and care in obtaining reliable estimates of the cost of stock options if these figures are included in companies income statements than they currently do for footnote disclosure. Our colleague William Sahlman in his December 2002 HBR article, Expensing Options Solves Nothing, has expressed concern that the wealth of useful information contained in the footnotes about the stock options granted would be lost if options were expensed. But surely recognizing the cost of options in the income statement does not preclude continuing to provide a footnote that explains the underlying distribution of grants and the methodology and parameter inputs used to calculate the cost of the stock options. Some critics of stock option expensing argue, as venture capitalist John Doerr and FedEx CEO Frederick Smith did in an April 5, 2002, New York Times column, that if expensing were required, the impact of options would be counted twice in the earnings per share: first as a potential dilution of the earnings, by increasing the shares outstanding, and second as a charge against reported earnings. The result would be inaccurate and misleading earnings per share. We have several difficulties with this argument. First, option costs only enter into a (GAAP-based) diluted earnings-per-share calculation when the current market price exceeds the option exercise price. Thus, fully diluted EPS numbers still ignore all the costs of options that are nearly in the money or could become in the money if the stock price increased significantly in the near term. Second, relegating the determination of the economic impact of stock option grants solely to an EPS calculation greatly distorts the measurement of reported income, would not be adjusted to reflect the economic impact of option costs. These measures are more significant summaries of the change in economic value of a company than the prorated distribution of this income to individual shareholders revealed in the EPS measure. This becomes eminently clear when taken to its logical absurdity: Suppose companies were to compensate all their suppliersof materials, labor, energy, and purchased serviceswith stock options rather than with cash and avoid all expense recognition in their income statement. Their income and their profitability measures would all be so grossly inflated as to be useless for analytic purposes only the EPS number would pick up any economic effect from the option grants. Our biggest objection to this spurious claim, however, is that even a calculation of fully diluted EPS does not fully reflect the economic impact of stock option grants. The following hypothetical example illustrates the problems, though for purposes of simplicity we will use grants of shares instead of options. The reasoning is exactly the same for both cases. Lets say that each of our two hypothetical companies, KapCorp and MerBod, has 8,000 shares outstanding, no debt, and annual revenue this year of 100,000. KapCorp decides to pay its employees and suppliers 90,000 in cash and has no other expenses. MerBod, however, compensates its employees and suppliers with 80,000 in cash and 2,000 shares of stock, at an average market price of 5 per share. The cost to each company is the same: 90,000. But their net income and EPS numbers are very different. KapCorps net income before taxes is 10,000, or 1.25 per share. By contrast, MerBods reported net income (which ignores the cost of the equity granted to employees and suppliers) is 20,000, and its EPS is 2.00 (which takes into account the new shares issued). Of course, the two companies now have different cash balances and numbers of shares outstanding with a claim on them. But KapCorp can eliminate that discrepancy by issuing 2,000 shares of stock in the market during the year at an average selling price of 5 per share. Now both companies have closing cash balances of 20,000 and 10,000 shares outstanding. Under current accounting rules, however, this transaction only exacerbates the gap between the EPS numbers. KapCorps reported income remains 10,000, since the additional 10,000 value gained from the sale of the shares is not reported in net income, but its EPS denominator has increased from 8,000 to 10,000. Consequently, KapCorp now reports an EPS of 1.00 to MerBods 2.00, even though their economic positions are identical: 10,000 shares outstanding and increased cash balances of 20,000. The people claiming that options expensing creates a double-counting problem are themselves creating a smoke screen to hide the income-distorting effects of stock option grants. The people claiming that options expensing creates a double-counting problem are themselves creating a smoke screen to hide the income-distorting effects of stock option grants. Indeed, if we say that the fully diluted EPS figure is the right way to disclose the impact of share options, then we should immediately change the current accounting rules for situations when companies issue common stock, convertible preferred stock, or convertible bonds to pay for services or assets. At present, when these transactions occur, the cost is measured by the fair market value of the consideration involved. Why should options be treated differently Fallacy 4: Expensing Stock Options Will Hurt Young Businesses Opponents of expensing options also claim that doing so will be a hardship for entrepreneurial high-tech firms that do not have the cash to attract and retain the engineers and executives who translate entrepreneurial ideas into profitable, long-term growth. This argument is flawed on a number of levels. For a start, the people who claim that option expensing will harm entrepreneurial incentives are often the same people who claim that current disclosure is adequate for communicating the economics of stock option grants. The two positions are clearly contradictory. If current disclosure is sufficient, then moving the cost from a footnote to the balance sheet and income statement will have no market effect. But to argue that proper costing of stock options would have a significant adverse impact on companies that make extensive use of them is to admit that the economics of stock options, as currently disclosed in footnotes, are not fully reflected in companies market prices. More seriously, however, the claim simply ignores the fact that a lack of cash need not be a barrier to compensating executives. Rather than issuing options directly to employees, companies can always issue them to underwriters and then pay their employees out of the money received for those options. Considering that the market systematically puts a higher value on options than employees do, companies are likely to end up with more cash from the sale of externally issued options (which carry with them no deadweight costs) than they would by granting options to employees in lieu of higher salaries. Even privately held companies that raise funds through angel and venture capital investors can take this approach. The same procedures used to place a value on a privately held company can be used to estimate the value of its options, enabling external investors to provide cash for options about as readily as they provide cash for stock. Thats not to say, of course, that entrepreneurs should never get option grants. Venture capital investors will always want employees to be compensated with some stock options in lieu of cash to be assured that the employees have some skin in the game and so are more likely to be honest when they tout their companys prospects to providers of new capital. But that does not preclude also raising cash by selling options externally to pay a large part of the cash compensation to employees. We certainly recognize the vitality and wealth that entrepreneurial ventures, particularly those in the high-tech sector, bring to the U. S. economy. A strong case can be made for creating public policies that actively assist these companies in their early stages, or even in their more established stages. The nation should definitely consider a regulation that makes entrepreneurial, job-creating companies healthier and more competitive by changing something as simple as an accounting journal entry. But we have to question the effectiveness of the current rule, which essentially makes the benefits from a deliberate accounting distortion proportional to companies use of one particular form of employee compensation. After all, some entrepreneurial, job-creating companies might benefit from picking other forms of incentive compensation that arguably do a better job of aligning executive and shareholder interests than conventional stock options do. Indexed or performance options, for example, ensure that management is not rewarded just for being in the right place at the right time or penalized just for being in the wrong place at the wrong time. A strong case can also be made for the superiority of properly designed restricted stock grants and deferred cash payments. Yet current accounting standards require that these, and virtually all other compensation alternatives, be expensed. Are companies that choose those alternatives any less deserving of an accounting subsidy than Microsoft, which, having granted 300 million options in 2001 alone, is by far the largest issuer of stock options A less distorting approach for delivering an accounting subsidy to entrepreneurial ventures would simply be to allow them to defer some percentage of their total employee compensation for some number of years, which could be indefinitelyjust as companies granting stock options do now. That way, companies could get the supposed accounting benefits from not having to report a portion of their compensation costs no matter what form that compensation might take. What Will Expensing Involve Although the economic arguments in favor of reporting stock option grants on the principal financial statements seem to us to be overwhelming, we do recognize that expensing poses challenges. For a start, the benefits accruing to the company from issuing stock options occur in future periods, in the form of increased cash flows generated by its option motivated and retained employees. The fundamental matching principle of accounting requires that the costs of generating those higher revenues be recognized at the same time the revenues are recorded. This is why companies match the cost of multiperiod assets such as plant and equipment with the revenues these assets produce over their economic lives. In some cases, the match can be based on estimates of the future cash flows. In expensing capitalized software-development costs, for instance, managers match the costs against a predicted pattern of benefits accrued from selling the software. In the case of options, however, managers would have to estimate an equivalent pattern of benefits arising from their own decisions and activities. That would likely introduce significant measurement error and provide opportunities for managers to bias their estimates. We therefore believe that using a standard straight-line amortization formula will reduce measurement error and management bias despite some loss of accuracy. The obvious period for the amortization is the useful economic life of the granted option, probably best measured by the vesting period. Thus, for an option vesting in four years, 148 of the cost of the option would be expensed through the income statement in each month until the option vests. This would treat employee option compensation costs the same way the costs of plant and equipment or inventory are treated when they are acquired through equity instruments, such as in an acquisition. In addition to being reported on the income statement, the option grant should also appear on the balance sheet. In our opinion, the cost of options issued represents an increase in shareholders equity at the time of grant and should be reported as paid-in capital. Some experts argue that stock options are more like contingent liability than equity transactions since their ultimate cost to the company cannot be determined until employees either exercise or forfeit their options. This argument, of course, ignores the considerable economic value the company has sacrificed at time of grant. Whats more, a contingent liability is usually recognized as an expense when it is possible to estimate its value and the liability is likely to be incurred. At time of grant, both these conditions are met. The value transfer is not just probable it is certain. The company has granted employees an equity security that could have been issued to investors and suppliers who would have given cash, goods, and services in return. The amount sacrificed can also be estimated, using option-pricing models or independent estimates from investment banks. There has to be, of course, an offsetting entry on the asset side of the balance sheet. FASB, in its exposure draft on stock option accounting in 1994, proposed that at time of grant an asset called prepaid compensation expense be recognized, a recommendation we endorse. FASB, however, subsequently retracted its proposal in the face of criticism that since employees can quit at any time, treating their deferred compensation as an asset would violate the principle that a company must always have legal control over the assets it reports. We feel that FASB capitulated too easily to this argument. The firm does have an asset because of the option grantpresumably a loyal, motivated employee. Even though the firm does not control the asset in a legal sense, it does capture the benefits. FASBs concession on this issue subverted substance to form. Finally, there is the issue of whether to allow companies to revise the income number theyve reported after the grants have been issued. Some commentators argue that any recorded stock option compensation expense should be reversed if employees forfeit the options by leaving the company before vesting or if their options expire unexercised. But if companies were to mark compensation expense downward when employees forfeit their options, should they not also mark it up when the share price rises, thereby increasing the market value of the options Clearly, this can get complicated, and it comes as no surprise that neither FASB nor IASB recommends any kind of postgrant accounting revisions, since that would open up the question of whether to use mark-to-market accounting for all types of assets and liabilities, not just share options. At this time, we dont have strong feelings about whether the benefits from mark-to-market accounting for stock options exceed the costs. But we would point out that people who object to estimating the cost of options granted at time of issue should be even less enthusiastic about reestimating their options cost each quarter. We recognize that options are a powerful incentive, and we believe that all companies should consider them in deciding how to attract and retain talent and align the interests of managers and owners. But we also believe that failing to record a transaction that creates such powerful effects is economically indefensible and encourages companies to favor options over alternative compensation methods. It is not the proper role of accounting standards to distort executive and employee compensation by subsidizing one form of compensation relative to all others. Companies should choose compensation methods according to their economic benefitsnot the way they are reported. It is not the proper role of accounting standards to distort executive and employee compensation by subsidizing one form of compensation relative to all others. A version of this article appeared in the March 2003 issue of Harvard Business Review .