Employee Stock Options Must be Treated as Expenses 325
currivan writes "In a move that's been in consideration for a long time, the Financial Accounting Standards Board (FASB) approved new rules requiring employee stock options to be treated as expenses for reporting purposes. One of the reasons so many tech companies have given options to IT/engineering workers is that until now, they haven't counted against profits in quarterly reports. If markets were truly efficient, this wouldn't make a difference, but in reality, the tech industry is strongly opposed to the rule, though it should please Warren Buffett."
It's about god damn time. (Score:3, Informative)
The surest way you know a company knows what its doing is if it's turning a profit. This should take one more accounting trick away from the pretenders out there.
Option value (Score:5, Informative)
In a year's time, the stock could be worth more than K, in which case the option's intrinsic value will be S-K, or it could be worth less, in which case the intrinsic value will be 0.
The extrinsic value of the option is what it's worth in the market, and presumably what it will be charged at in the accounts. It's calculated by taking the expected intrinsic value at expiry.
For our example, let's imaging there's a 25% change of the stock being worth each of 70, 90, 110 or 130 in on year's time (we'll assume it can't take any other value). The expected value of the stock in a year's time is 100 just as it is now:
E[S] = 0.25 x (70 + 90 + 110 + 130)
= 100
However, the expected intrinsic is...
E[max(S-K,0)] = 0.25 x (0 + 0 + 10 + 30)
= 10
So the value of the option is 10.
Of course, there's more to it than that. The distribution of possible stock prices is continuous. We've also ignored the fact that I'd a dollar today is worth more than a dollar in a year's time. There are theories on how to value these things...
Here is the FASB's FAQ (Score:4, Informative)
This change would have occurred 10 years ago if Congress hadn't interfered on behalf of companies trying to hide their largesse from shareholders. The rest of the world is in the process of implementing a similar accounting treatment of options. The US would have looked idiotic to have delayed this further.
Re:Hmmmm (Score:5, Informative)
Re:How will it work? (Score:3, Informative)
Yay...I get to show off my knowledge of finance on
The "exercise" or "strike" price is the price at which you may buy the stock. It could be below current prices, in which case you'd make an immediate profit. When the strike price is below the current stock price, the option is considered "in the money." When the strike price is above the current market price, you can't make a profit right away and the option would be considered "out of the money." However, just because an option is out of the money doesn't mean it's worthless. Between the growth in the value of the company and the volatility of the stock price, there is still a possibility that it could be in the money before expiration.
Re:How will it work? (Score:3, Informative)
However, what the FASB rules say and what the IRS rule say can be different. I don't think the IRS has ruled on this area yet, they were seeing if FASB could work it out and maybe jump on that. And yes, companies DO pay taxes, but it's at a fixed rate. They however get lots of tax deductions you and I can't get.
I suspect you will start seeing some funky statements in earnings reports like you mention. I think the Stock Analysts will ignore it, as Earnings are only 1 component of what they measure to "estimate" the stock price. Cash Flow (which options do not affect) is a better measure of how strong a company is for the future.
By the way, I don't think the rank and file techie options are driving this FASB statement, it's more the massive options given to the techie (and other) EXECUTIVES that they are concerned with.
Black-Scholes (Score:3, Informative)
Re:How will it work? (Score:3, Informative)
A Couple of Articles on the Matter (Score:3, Informative)
HERE [64.233.161.104]
Re:Buffet's pi reference (Score:3, Informative)
It was Indiana [purdue.edu]. The reference you cite is talking about a hoax; Indiana actually did present a bill.
Re:Tax Implications? (Score:5, Informative)
Re:How will it work? (Score:3, Informative)
When options are granted, you are getting an option to buy a certain number of shares before a certain expiration date. The option to buy shares is a "call" option.
You're talking options as the ones traded on the Chicago Borad Options Exchange. Employee stock options are a different beast - unlike market options, they are not transferable and (for the most part) never expire. They are also not clearly defined, because they sometimes void if your employment is terminated, but sometimes they have "triggers" in them whereby they automatically vest upon employment termination unless your employment is terminated "for cause" (i.e. you got fired for doing something bad). The options with triggers are subjectively more valuable, but how (and why?!) you'd want this reflected on the books escapes me completely.
Re:How will it work? (Score:1, Informative)
(1)The basic premise is that if the stock is risk free and no dividends are paid out then the stock should appreciate the same way a bond would.
(2) secondly you adjust for risk. The more risky a stock is the more the option is worth. The reason is that the down side risk is limited(the options minimum value is zero) while the up side is theoretically unlimited.
(3) you adjust for expected dividends.
And yes, this is a huge improvement seen from the (fiancial) market's view point. I'm a economics student(I have studied and written reports on a few companies) and let me tell you: Correcting for stock option is often the most annoying aspect lack of disclosure makes valuation very difficult. This is a Good Thing, especialy for small investors that lack the intricate knowledge that is required to unravel the often very complicated options schemes
Re:How will it work? (Score:3, Informative)
That may be true, but that is a good thing.
1) Investors should be able to look at the financial details and see how much liability there is. As an investor, you may want use stock options as a metric about how a company is run.
2) Stocks options are not 'free money'. When a company gives them away, they create a liability to the shareholds and dilute the value of a company. Just like the US Federal Gov't uses financial trickery to move certain expenses 'off budget', options hide the true financial health of a company.
3) Financial reports represent a snapshot in time. Why shouldn't the expense of options be declared in that snapshot.
4) Options are given out too easily because they don't show up on the bottom line.
5) This is truly common sense because you should always err on the side of full disclosure.
6) Most experts agree that this makes sense, they've agreed for a long long time (pre dot com days). The lobby against it has been from people who are more interested in their personal pocket books than the overall health of the financial system.
Re:Hmmmm (Score:5, Informative)
Under accrual-based accounting, options are always recorded at cost, so they always have value (par value or stated value plus or minus paid-in capital). Under accrual based-accounting, no buying or selling has to occur for it to be recorgnized and recorded. A mere "promise" satisfies the principle of materiality required to record the event.
In other words, it sounds as if stock options, which weren't liabilities in the past, should now be recorded as liabilities on the accounting period in which they are given. This is important because liabilities that represent expenses are significant to judging the state of the corporation even when they yet haven't actually been expensed yet.
Per FASB guidelines, all corporate accounting in the United States has to be accrual-based. The only entities that still use cash-based accounting are government entitites. With the new ruling, pretty much everyone but the government has to change the way in which stock options are recorded. So your point, though intuitive when thinking in cash terms, is largely inapplicable to everyone but the government.
Wiki link - Option values (Score:2, Informative)
http://en.wikipedia.org/wiki/Black_Scholes
Re:Option value (Score:1, Informative)
On the parent's expected value evaluation, this option is worthless. Under black-scholes and binomial, this option is worth exactly $5.
If someone is willing to sell it for less, say $4, I can make money risk free (arbitrage) by buying 2 options for $8, selling one stock short for $100. In six months, it does not matter whether the stock went up to $110 or down to $90, I make $2. If it goes down to $90, then I cover my short for $90 and thus I received $100, lost $90, and spent $8 for a $2 profit. If it goes up to $110, I cover my short and exercise both options thus I received $100, lost $110, spent $8, and exercised for $20 with again a $2 profit.
If someone is willing to buy the options for more than $5 (say $6), then I sell two options for $12 and buy one stock for $100. Six months later I sell the stock. If this price is $90, then the $12 earlier makes up for the $10 loss and no one exercises. If the stock price is $110, then I made $10 on the stock, got $12 for selling the options and pay out $20 when others exercise their options on me. In both cases I make $2.
In summary, option prices should be valued on their expected volatility, not their expected value. The big problem with using Black-Sholes on employee stock options is that people are not allowed to sell short on the stock so as to convert their options into cash (i.e the market is not efficient).
So Black-Sholes stinks but using expected value for options gives even more misleading values. Employers talk about options as if expected value was the way to value them but always say they use black sholes, yet refuse to let you sell your shares. I dont know if they are ignorant or dishonest.
Employees just beware I guess and do not be fooled by expected value or by Black Sholes without the opportunity to sell short on shares.