Beyond employee salaries, bonuses, and health benefits, some companies offer Employee Stock Options (ESO) to allow the employee to own stock in the company and invest in its future. Stock options may be considered a form of compensation which gives the employee the right to buy an amount of company stock at a set price during a certain time period. Under U.S. accounting methods, stock options are expensed according to the stock options' fair value.
In 2004, the Financial Accounting Standards Board (FASB) issued a revision to Statement No. 123 on accounting for stock-based compensation. Prior to this change, Accounting Principles Board Opinion 25 provided for intrinsic value accounting for stock options. Intrinsic value accounting calculated the difference between the market value of the stock and the exercise price when the option was issued. Most companies offered an exercise price equal to the market price at the time, leaving an expense of zero.
Fair value accounting is now the U.S. generally accepted accounting practice for employee stock options. The fair value is considered a business expense and included in the company's income statement as a footnote. The fair-value method uses the value of the stock on the award date based on an option-pricing model, such as the Black-Scholes Model.
Under the Black-Scholes model, stock options are not given an intrinsic value at the time they are granted, but rather a time value. The fair value makes a number of assumptions about the future of the stock, based on minimum value and volatility. The minimum value may assume the stock will have a growth rate at least at the level of a risk-less stock, such as the U.S. Treasury yield rate.
The minimum value may also be determined based on the option term, stock price, dividend yield, and exercise price. Additionally, the value assumes the options will be exercised by the employee at some time during the option term, and the stock is tradable at the holder's option. Companies are required to disclose the stock options in a financial statement.
Some critics of the fair value accounting method argue that the eventual value of the option is difficult to approximate before the option is exercised. Given the difficulty in valuing options, some argue that the options should not be expensed. Stock options are disclosed as a footnote, but they are not required to recognize the option as an expense.
Expensing options uses a formula to estimate the cost of options. However, when a stock price drops dramatically during the option period, the expense estimate would be overstated. Similarly, if the stock price rose dramatically, the expense estimate could be greatly understated.
Butterfield Schechter LLP is San Diego County's largest firm focusing its law practice on employee benefits and business services. Our firm can help your business take advantage of accounting and tax regulations while offering employees valuable benefits. We can help your business implement employee stock options or an ESOP. Contact our office today with any questions on how we can help you and your business succeed.