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Theories of Accounting for Stock Options

Stock options represent a significant component of employee compensation. Theoretically, it has often been argued that the inclusion of stock options in employee and executive compensation increases managers’ participation thus increasing the market value of the firm’s stock. With the devastating impact of recent accounting scandals in the U.S, accounting standards for regulating the treatment of stock options continue to be controversial. To what many may consider as a form of incentive, U.S national statistics argue that accounting rules for stock options does not accurately represent workers total compensation in calculating salaries and wages. Moreover, company executives seem to have misapplied the entity concept for their own selfish interest. It’s widely understood that all forms of accounting standards involve some risks but should managers misapply the entity concept to fit their desired results?

Controversies of Stock Options

Since most accounting theories involve some risks, accountants and policy makers should be cognizant of all the shortcomings of the proposed accounting standards to ensure that managers are made aware of the potential risks of each module before its implementation.The debate in this essay points out on how the application of the entity concept that is consistence with financial requirements which requires entity transactions to be accounted for separately from its owners. The entity theory needs to be re-examined in relation to employees, the entity itself and its owners (McIntosh, 2000, p.2: Ross et al 2009).

In business, many transactions are interwined, or triangulated, and in this case, expensing for stock options is a three way relationship between employees, the entity and shareholders. Accounting treatments for employee stock options are generally found in SFAS 123, and APB 2. The two accounting measures have not embraced stock options valuations as a measurement concept. The view has led to the two dimensional accounting standards that have stemmed controversies all over the United States (McIntosh, 2000, p.2).

In terms of accounting theories that apply to stock options, I will evaluate incentive stock options (ISO) and nonqualified stock options (NSO) as practiced in the U.S. Employee stock options for instance does not consider investors when employing the accounting techniques but instead uses estimates on interest rates, asset lives or fair vales based on estimates which could subsequently produce biased results that only fits their executives interest. This theory has failed to capture the triangular transactions involving employees, the company and shareholders. (McIntosh, 2000, p.2)

When incentive stock option is exercised, employee is only taxed when the stock is sold. This however requires the employee to have held the stock for at least two years from the date the stocks were issued and 1 year from the exercise date which exempts them from tax deductions for the stock option transaction. And in a case where the employee does not meet the required holding period, the gains are taxed as compensation and an employer receives wage deductions. In nonqualified stock option, gains are calculated from the exercise date and therefore taxed as ordinary income regardless of the amount of time the stocks were held. In this instance, the employee receives a deduction equal to the amount of income they were subjected to. NSO application reduces the tax paid by the employer obviously lowering the net income received by an employee. Needless to say, the deductions are posted to the financial statements contrary accounting rules requirements (McIntosh, 2000, p.2).

The accounting theory of stock option represents the operating costs of the company and often considered as a form of compensation. The FASB conceptual framework therefore requires the cost of stock option compensation to be reflected in the income statement and matched against the employee benefits over their service period. Based on the Statement of Financial Accounting Standards (SFAS) 123, known as the Accounting for Stock-Based Compensation, companies are required to account for their employee stock options in financial statements at the time the stocks were granted, a practice often omitted by business executives (McIntosh, 2000, p.2).

Another accounting module, APN Opinion No. 25 issued in 1972, for instance measures the intrinsic value of stock options by subtracting the exercise price from the fair market value as at the date the stock option was granted. Since the difference was in most cases zero, compensation expense in this case must be realized over the stock options vesting period. In this case, most companies understate the true values of compensation costs and overstate their profits. Redirecting my focus from recognition and measurement to usefulness of disclosures should be given top priority in the new accounting proposal to restore investors’ confidence (McIntosh, 2000, p.2).

The accounting theories and tax consequences for stock options have made the collection of data for U.S national income and product accounts (NIPA) a very complicated practice. For example, the 1993 System of National Accounts failed to explicitly give guidance for stock options for employees’ stock compensation. Secondly, NSO and ISO have different tax treatments which appear confusing on whether to be classified as compensation or an expense. Thirdly, the different accounting rules employed by companies in reporting profits and expenses produces inconsistence data for compiling the national income and product accounts (McIntosh, 2000, p.2)

NIPA often employs estimates from BLS for the unemployment insurance program (IU) in calculating wages and salaries. The UI data derived from the administrative tax records are often assumed to include NSOs but not ISOs, In this case stocks are not identified separately on tax forms, but we see that when NSOs is exercised, stock options will be classified as expenses and therefore deducted from companies. This tax data collected here are not incorporated into the NIPA until the second annual revisions for a given year. Also, the value of the stock is only included when the stock option is exercised even though the stock had value at the time it was granted. Although FAS 123 accounting theory requires companies to use option-pricing model to value options, the treatment can not be exercised due to lack of source data (McIntosh, 2000, p.2)

The U.S financial accounting requires net equity issuance by nonfinancial corporations to buy back shares in anticipation of stock options being exercised now or in the future periods as well as the stock being issued at the time of stock option. Here the stock option price value is often equal to the exercise price, and not the market price as reported earlier. Again, the stock buy back is recorded at market value and exercise option recorded as exercise price. The exercise option results to capital gains in equity holding on the balance sheet (McIntosh, 2000, p.2)

Since the FASB requires companies to expense the fair value of stock option, an exercise highly criticized by high technology companies since they would eliminate stock options if expensing was required by FASB. It was argued that companies exercising stock options and exposed to earning per share (EPS), their earnings would be reduced if they recognized the extra expense subsequently hurting their stock prices. Therefore high technology companies’ financial results would greatly be affected if they used stock options compensation to lure high talented executives to run their companies. Findings collected from Standard and Poor’s 500 companies reported that stocks over 9% declined in the following year if expense recorded for fair value of stocks options were issued. High tech companies are a bit reluctant in exercising expense for stock options since stocks are their major components for executive compensation and use of fair value expense will affect their financial statements to a great extent (Baviera, 2004, online).

Although FASB requires companies to expense the fair value of stock options, this methodology is rarely practiced because of the significant effect it has on the net income as many companies choose to apply APB 25. Companies like Enron and WorldCom were reported to have boosted their income through stock options but did not expense their stock options granted to employees. Also, the inappropriate accounting standards applied by Enron that led to its collapse were attributed from influenced from the executive management desire to increase share prices through their misstatements of their financial information. Frauds in financial statements have been proven to damage the perceived usefulness of disclosures. Since the recent accounting scandals, business leaders are opting for better accounting for stock options in an attempt to increases investors confidence. Coca Cola for example, hurried to change its accounting methods in 2002, from the intrinsic value method to recognizing stock option expense. Later on March, 2003, FASB announced a new project that will improve financial accounting disclosures for stock options compensations. The project was proposed to find better ways to measure stock options expense and proposed for one method of accounting for stock options that are consistence with financial data (Wrege et al, 2005, p.3).

The Exposure Draft states that, “The Objective of accounting for transaction under share-based payment arrangement with employees is to recognize as an expense in the income statement the cost to the entity of services received (and consumed) in exchange for equity instruments issues, or liabilities incurred.” (Wrege et al, 2005, p.7). Here the draft specifies that compensation costs are determined by fair value of the equity instrument issues eliminating the alternative use of fair value services. Therefore the fair value of stock options is charged as an expense over the requisite service period it was issued which cannot be re-measured after the grant date. Also, the proposed draft that requires expenses to be based on share payments does not accurately reflect economic reality (Wrege et al, 2005, p.8). Another paragraph of the draft quoted by Wrege et al states that “Public entities should measure the cost of employee services received in exchange for wards of equity in investments based on the fair value of the instruments of the grant date” (2005, p.7). Since the proposal assumes transactions to be costs, it would be confusing to know which shareholder suffers the costs.

Accounting treatment for stock option expenses are often confusing to many often leading to inconsistency in financial statements. For example, at the 2002 financial markets Conference of the Federal Reserve Bank of Atlanta, Alan Greenspan statement as analyzed by Baviera illustrated that “Stock options is an unilateral grant value from the existing shareholder to an employee” (2004, online). This statement is itself contradictory in nature. Here Greenspan supports the expensing for stock options when he identifies stock options to be part of shareholders and employees and not the linked to the organization. We can also see that when a company owns its own shares, it does not account for them as corporate assets but as treasury stocks and when it decides to grant its stocks, it’s never considered as transferring assets nor creating corporate liability but rather compensating for share guarantees (Baviera, 2004, online).

Conclusion

It’s widely understood that all forms of accounting standards involve some risks but should managers misapply the entity concept to fit their desired results Stock options are considered here as employee compensation and should not be considered as performance measurement issued by the company. The current accounting standards exercised in stock options does not effectively diagnose the transaction shortcomings.

References

Baviera, G. J., & Walther, L.M. (2004). Stock Options Accounting: Defying the Usual Answers. The CPA Journal online. Web.

McIntosh, S. H. (2000). Accounting for Stock Options in the United States. U.S. Department of Labor. pp. 1-2

Ross, S., & Westerfield, R., Jaffe, J., & Jordan, B. (2nd ed.). (2009). Corporate finance: Core principles and applications. Boston, MD : McGraw-Hill Irwin

Wrege, W., Myring, M., Schroeder, J., & Ermst and Young. (2005). Accounting For Stock Based Employee Compensation: A Continuing Controversy. Journal of Business & Economics Research, Vol. 3, No.4, pp.1-8