January 2003

Expensing Stock Options Or Not: Does It Matter?

By Nashwa E. George
John Wiley & Sons, Inc., 2002; $75.00;
ISBN: 0-471-41437-9
Reviewed by Robert N. Waxman

Stock options, initially created to retain executives and attract new talent, give executives the right to buy company stocks at a given price over a period of time. SFAS 123, Accounting for Stock-Based Compensation, gives companies two alternatives to account for stock-based compensation:

• A company can adopt the fair value method (SFAS 123) to account for employees’ stock options. Compensation is based on the fair value of the options that are expected to vest on the grant date, and the option is considered
  an expense.
• A company can use the intrinsic value method (APB Opinion 25) which usually does not require a charge to earnings for stock options granted to executives as compensation. It discloses the impact on net income and EPS if stock options were recorded as an expense in income statements.

The majority of companies account for stock options under the second alternative. The International Accounting Standards Board (IASB), as well as standards setters, wants companies to include the cost of stock options as an expense in income statements.

In June 2002, Standard and Poor’s (S&P) presented a project to improve the consistency of reported financial results and make earnings reports easier to understand. The project introduces a “core earnings” measurement that includes stock options as an expense. S&P’s rationale for including the cost of stock options as an expense is that this type of compensation should be treated in the same way as all other compensation elements.

To be recorded as an expense, stock options should meet the definition of expenses according to FASB Concept Statement 6. Expenses are outflows, using up of assets, or incurrence of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. Expenses represent actual or expected cash outflows that have or will occur as a result of the entity’s ongoing operations.

Fixed stock options are given to executives as compensation for services rendered. Granting stock options, however, entails no outflows, use of assets, or incurrence of liabilities. When executives exercise options, they pay cash and the company issues common stock. There are inflows of assets and an increase in equity. When stock options expire without being exercised, there is no change in a company’s assets, liabilities, or equity. Stock options should be recorded as an expense as well as a liability. The method a company uses to evaluate stock options does not matter as long as it justifies its calculation.

Under the intrinsic method (APB Opinion 25), compensation expense equals the difference between stock market price and stock exercise price at the grant date. In most cases, the two prices are equal and compensation cost is zero. Under the fair value method (SFAS 123), compensation expenses are calculated using any options pricing model (such as Black-Scholes). In this case, compensation expense is not zero.

The following example is used to explain the impact on income statements, balance sheets, and cash flows in two separate cases:

• A company records stock options as an expense.
• The same company does not expense stock options.

Example

On January 1999, ABC Company granted 10,000 stock options to its executives. Using the fair value method, total compensation was $100,000. Service periods were for 1999 and 2000 equally. Options would expire after five years.

Case 1: Recognize stock options as an expense. According to SFAS 123, the following journal entries are required to record fixed stock options:

• At grant date January 1, 1999, no entry is required
• December 31, 1999, and December 31, 2000, to recognize compensation expenses:

Dr. Compensation expense $50,000
Cr. Add’l paid-in capital stock options $50,000

As the entry shows, recording compensation expenses does not reduce asset or increase liability, but it does increase total stockholders’ equity. There is no real increase in the equity and the credit side of the entry should be a liability to issue stock when executives exercise their options.

• Assume 80% of stock options were exercised for $64,000 cash and common stock par value was $5; to record the issue of stock upon the exercise of options:

Dr. Cash $64,000
Dr. Add’l paid-in capital: stock options $80,000
Cr. Common stocks $40,000
Cr. Add’l paid-in capital over par $104,000

As the entry shows, exercising stock options does not decrease assets or increase liabilities but it increases assets and equity. The debit side should delete a liability of $80,000.

• Assume that the remaining 20% of stock options expired at the end of the exercisable period. The entry is:

Dr. Add’l paid-in capital: stock options $20,000
Cr. Add’l paid-in capital: expired options $20,000

The result of this entry is no change in assets, liabilities, or equity.

The impact of previous entries. Recording compensation expenses decreases the net income and the retained earnings by $50,000 in 1999 and 2000. Earnings per share (EPS) decreases as well. The decrease in the retained earnings does not decrease total stockholders’ equity because the additional paid-in capital increases by the same amount. There is no impact on cash flow.

Recording issuance of the common stock upon exercise of the stock options increases the assets and the equity and has no impact on liabilities or net income. Recording expired stock options has no impact on assets, liabilities, or equity.

The true impact on a company’s financial statements should be on the date stock options are exercised, because if options were granted but never exercised, there would be no impact on net income, assets, liabilities, or equity.

Case 2: Do not recognize stock options as an expense. When stock options are not recorded as an expense in income statements, there is no decrease in net income by $50,000 of compensation expenses for 1999 or 2000. There is also no corresponding increase in additional paid-in capital. The net effect on the total stockholders’ equity is zero.

If executives exercised their stock options and common stock was issued, the same entries should be recorded as in case 1. Comparing the income statement from case 1 to case 2, it is clear that recognizing stock options as an expense reduces net income and EPS. Although stock options granted to executives should be deducted as an expense in income statements, analysts and users of financial statements should also consider the impact on balance sheets and cash flows. Under both cases, there is no change in book value of total stockholders’ equity, and there are no cash outflows because of stock options granted or exercised.

The following schedule shows the average net income and EPS for a sample of 1500 large and medium sized companies if companies did and did not expense stock options:

* In billions of dollars

Recommendations

The purpose of granting options to executives, to align their compensation incentives with increased shareholder value, was not accomplished because executives still try to increase their company’s stock price to profit from their stock options when they exercise them. Nonetheless, with the drop in stock prices, millions of stock options are under water and companies are reevaluating stock option plans.

Stock options should be deducted as an expense in income statements with the following recommendations to control their use:

• Options grant agreements should require executives to stay a specific period with the company after exercising their options or should forbid them from selling their stocks for some years after the exercise of options.
• All stock options should be limited to a certain percentage of total common stock outstanding, and options granted should be approved by shareholders and disclosed in detail in financial statements.
• The SEC should issue guidance regarding stock options because unless the true cost of granting stock options is apparent to investors, companies will not stop using them and the stock market will continue to suffer.

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