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Employee Stock Options - Transactions Affecting Shareholders’ Equity
Stock options are rights to purchase a firm’s stock at a specific price at some designated period in the future. Although stock options are sometimes sold directly to investors, they are usually granted as part of the compensation paid to key executives and other employees. Stock options, as a means of compensation, offer several distinct benefits to firms and employees. Because the value of stock options depends on the future market price of the firm’s stock, option holders are highly motivated to improve the performance of the firm. Actions that benefit the firm’s stockholders also directly benefit the option holders. As a result, managers and other employees who hold stock options have the same objective as company shareholders: to make the firm’s equity securities more valuable. In addition, although option holders gain if the price of the optioned stock subsequently rises, they avoid the “downside risk”of loss if the stock price declines. If the stock price is below the option price, the option simply will not be exercised.
A more arguable advantage of stock options from the firm’s point of view is the manner in which options are currently handled in financial statements. Current accounting rules allow firms to choose between two different ways of reporting the cost of employee stock options, based either on intrinsic values or fair values of the options at the date of grant. The intrinsic value method measures the compensation cost of stock options as the excess of the stock’s market price over the option price at the date of the grant. Because most employee options are granted at or above market value, firms that elect this method do not recognize any compensation expense associated with the options. Under the alternative fair value method, compensation expense is measured at the grant date based on the estimated fair market value of the award. Fair values of options must be estimated based on a theoretical model and various assumptions. Estimated stock option values and related compensation expenses can vary significantly, depending on the assumptions used and the model selected.
To illustrate how stock options for employees are treated when the issuing firm employs the intrinsic value method, assume that Jetsom Inc. issued options to its employees to purchase one million shares of its common stock in 2001 at an option price of $10 per share, equal to the market price at the date of the grant. Subsequently, in 2005, assume that all the options were exercised when Jetsom’s market price per share had risen to $90.
For financial statement purposes, Jetsom records no compensation expense in 2001 when the options are granted. In 2005, when the options are exercised, Jetsom records the cash proceeds of $10 million ($10 * 1 million shares) as an issuance of common stock for cash.
Although this method of accounting for stock options is presently followed by U.S. firms, opponents of current practice argue that in situations like the Jetsom case the granting of stock options in 2001 should entail the recognition of compensation expense. The grantees were given valuable rights that might otherwise have been sold to other investors. Moreover, in 2005, Jetsom’s optioned shares had a market value of $90 million, yet these options had been issued to the option holders for only $10 million in cash. In retrospect, granting the options in 2001 seems to have cost Jetsom $80 million ($90 million market value less $10 million proceeds). Consequently, some accountants believe that reported compensation expense is understated and reported net income is overstated.
The value of employee stock options is often substantial in specific industries. In high-technology companies that rely heavily on stock options to attract and retain talented employees, it is estimated that stock-option-related compensation expenses, if measured using fair values, reduce net income anywhere from 10 to 100 percent (“Options’ Effect On Earnings Sparks Debate,” WSJ, May 13, 1998). For this reason, companies that elect not to recognize compensation expense using the fair value method must show net income and earnings per share in a footnote to the financial statements as if the fair value method had been used. Case study 9.2 shows a portion of such a footnote for a major technology company.
Case Study 9.2
Digital Equipment Corporation, a leading developer and producer of computer hardware and software, reports the following information in its 1997 financial statements:
Stock options granted during 1997: 3,750,800 shares at an average exercise price of $36.30 per share.
Stock options exercised during 1997: 647,222 shares at an average exercise price of $21.01 per share.
Net income (loss) applicable to common shareholders, as reported in the income statement:
Net income (loss) applicable to common shareholders if stock options granted during the year were valued at fair value:
Required
a. By how much does the market value of the shares after the exercise of the stock options during 1997 differ from the exercise proceeds received by the company? Would this difference affect your assessment of Digital’s compensation expense for 1997?
b. Digital uses the intrinsic value method to account for the cost of employee stock-based compensation. As a result, Digital did not recognize any expenses related to these stock options in 1997. How much would the compensation expense have differed in each year if the firm used the fair value method to measure this compensation expense?
Solution
a. The market value of the shares issued by Digital after the exercise of options during 1997 was $23,494,158 (647,222 shares * $36.30 per share). The exercise proceeds received by the company was $13,598,134 (647,222 shares * $21.01 per share). The difference between these amounts is $9,896,024 ($23,494,158 - $13,598,134). This difference represents the additional economic value of Digital’s shares above the amounts received from the option holders. Some analysts suggest that this additional value should be regarded as compensation cost.
b. The differences in compensation costs can be determined by comparing the net income amounts reported in the income statements and the amounts in the footnotes. In 1997 the compensation expense would be higher by $69,177,000 ($105,375,000 - 36,198,000), and in 1996 the compensation expense would be higher by $40,728,000 ($188,040,000 - $147,312,000). Note that in both years the additional expenses related to the stock options are substantially higher than the amount computed.
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