Accounting Treatment on Employee Stock Option
This tract provides a concise assessment of the employee stock options and the significance of the accounting treatment including its procedures and latest alterations. It overtly deem the vesting period, the possibility of employees leaving the company during the life of the option, the inability of employees to trade their options, and dilution issues based on the Financial Accounting Standards Board (FASB). This paper will also establish the pros and cons in having stock options as employees’ incentives as well as suggested methods in calculating the value of stock options.
1.0 Employee Stock Options
A stock option is offered by corporations to its employees as incentives giving them a privilege to an employee to purchase a stock of the company at a specified duration of time and at a specified price (Short, 2002).
To easily comprehend the subject and for the sake of certainty, the term options pertains to the options issued by the company on its own stock. There is a vesting period of during which the options cannot be exercised. Fundamental rules apply that when an employee leave their jobs (voluntarily or involuntarily) during the vesting period, they automatically forfeit their unvested options, however, if the employee leaves after the vesting period, they forfeit options that are out of the money and they have to exercise vested options that are in the money immediately. Employees are prohibited to sell their employee stock options. They must exercise the options and sell the underlying shares in order to realize a cash benefit or diversify their portfolios. And as for the company, once options are exercised, they will be required to issue a new and reformed Treasury Stock (Hull & White, 2003).
2.0 Accounting Treatment
One issue in expensing stock options concerns the timing of the recognition of the expense. Financial Accounting Standards Board (FASB) Section 123 favors recognizing the expense on the grant date. The company can choose to make an estimate of the options that will not vest and reduce the amount of the expense accordingly. Alternatively, it can calculate the expense on the assumption that all options will vest and later reverse the expense for those that do not.
In ED 2 the International Accounting Standards Board proposes that the value of the options be calculated on the grant date. If there is no vesting period, the expense is recognized immediately. If there is a vesting period, the expense is recognized year by year during the vesting period as the employees provide service for the company. FASB 123 regards employee stock options as akin to compensation that is almost certain to be received by the employee. IASB's ED 2 regards them as payment for services performed for the company by the employee during the vesting period.
FASB 123's interpretation of the nature of employee stock options is closer to reality. The grant date is the point in time when the company creates a contingent claim against its assets. Few employees regard employee stock options as payment for services provided during the vesting period. It also worth noting that, although the company usually has the option of changing an employee's regular compensation during the vesting period, it does not have the option of adjusting the terms of employee stock options during this period. In our view the vesting period in employee stock options is like the lockout period that is a feature of many over-the-counter derivatives contracts. The vesting period can be viewed as providing another dimension to the contingency in an employee stock option. The employee's ultimate payoff is contingent on how well the stock performs and on remaining employed. The same principles should be used in dealing with all contingencies.
Many of the debates concerning executive stock options center on whether they are liabilities of the company or equity claims against the company. The reality is that they are neither. Traditionally accountants have classified claims against a company as debt or equity. With the advent of derivatives markets the nature of the claims that can been outstanding against a company have become considerably more complex.
3.0 Use of Stock Options in Canada
Following an initiative decided during the 2001 annual meeting of OECD National Accounts Expert, Canada, being one of the non-European members implements the new accounting treatment for stock options for employees. The value of stock options in Canada, when exercised has been included up to taxation year 1999, as taxable benefits in the tax statement, called T4, which is submitted by employers to employees. The individual was also taxed on the capital gains, if any, upon the later disposition of the shares. The budget as of February 28, 2000 introduced an amendment to the Income Act to modify the way in which stock option are taxed. This proposal allows employees to defer unrealized gains from exercising stock options for publicly listed shares until the disposition of the shares. However, there is an annual limit of $100,000 subject to deferral. At present, under the Canadian business accounting principles, companies are not obliged to account for the value of equity remuneration in profit; thus, their reported profits are overstated. Following the budget change of 2000, the employer will calculate a benefit as was done in the past but now divided into two parts, one called stock option benefit the other deferred stock benefit. The deferred stock option benefit is not taxed until the disposition of the shares but the stock option benefit is taxable in the year it is reported (Lequiler, 2002).
3.1 For the compensational treatment, the recording in the Canadian System of National Accounts is driven by available data, based on T4 information. Gains from stock option are exercised and the value is calculated as the difference between market value and exercise price. The new system introduced in February 2000 did not changed Statistics Canada estimation method: both stock option benefit and deferred stock option benefit are included in labor compensation, even though the entire amount is not taxed. Sources for labor compensation are the T4 returns for the annual benchmarks. Monthly and quarterly estimates are built from the monthly establishments Survey of Earnings, Payroll, Hours (SEPH), which do not contain information on stock options. On the other hand, quarterly series are projected from the latest annual benchmarks of labor compensation and the corporations keep an eye on media reports to get hints of any major developments on stock options.
3.2 With regards to treatment on profits, the entire amount is expensed in the national accounts against the income. Profits are estimated from quarterly corporations survey and annual corporations returns to Canada Customs and Revenue Agency. These estimates are further benchmarked to the estimates of operating surplus derived from annual Input-Output tables.
4.0 Calculation of the Employee Stock Options Value Employers today are focusing increasing attention on the issue of how to value the options they grant to employees. Many simply want to know the value of what they are offering the employees. In addition, employers are moving more than ever toward expensing of the options they grant for earnings purposes – a practice that requires the employer to determine an accurate value of the granted options. Companies also need accurate option values to comply with FASB rules even if they do not expense the fair value but merely mention the values in footnotes (Olagues, 2002) Employees, too, want to know the value of their stock options, whether it is for purposes of evaluating an employment offer, understanding the significance of a new option award, or simply to value their options for investment management purposes. For employers and employees alike, then, the question would be about what method should be used to determine the value of employee stock options.
4.1 Black Scholes
Black Scholes, created in 1973 by Myron Scholes and Fischer Black, are mathematical models that give theoretical prices for a particular listed exchange-traded option at any particular time. These models incorporate such variables as the stock price, the exercise price, the expiration date of the option, the expected volatility, any dividends and the interest rate to produce theoretical values for listed stock options. These methods however are not guaranteed of 100% accuracy for some traders believe that like other methods, it has its own share of faults in valuation of listed-long term options as well as listed options on highly volatile stocks.
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