Employee compensation: stock options versus restricted stock.

The granting of stock options as compensation is beginning to lose its appeal. For many years, firms have awarded stock options to their employees as a way of aligning the goals of management with shareholders. Stock options are seen as an excellent motivational tool because firms can provide additional compensation incentives without having to record an offsetting compensation expense. Since their inception, stock options have avoided the accounting treatment of expense recognition. By avoiding the expense charge, a firm's balance sheet and performance ratios will always appear more attractive then they actually are. Thus, the firm's ability to raise capital will always be enhanced. However, the Financial Accounting Standards Board (FASB) is strongly considering requiring that the cost of employee stock options be treated as an expense. It is expected that a new standard will be adopted and firms will be required to record the expense of the options as early as 2004. Many large firms (such as GE, Coca-Cola, CitiGroup, and Bank of America) have already begun to record stock option compensation as an expense.

The rationale behind stock options as the executive compensation of choice for many firms has been attacked by shareholders, investors, and even employees of the firms. Shareholders and investors argue that these options are an expense and, when the expense goes unrecorded, the financial position of the company is not fully reflected in the financial statements. In addition, employees are complaining that the recent stock market decline has made their options worthless. So firms are looking at alternative methods of placing stock into the hands of their employees. Firms still believe that the incentive of receiving stock (ownership) in the employer is a powerful incentive for employees. The means of continuing to reward employees that is most often recommended is restricted stock. Restricted stock is stock that, when awarded to an employee, restricts the employee's rights to the stock until the shares have vested or the restriction (such as performance targets) has been satisfied.

Employee compensation expense has a significant impact on the lending decision of creditors. While compensation expenditures are typically evident to lenders, determining the real expense of different compensation plans is not a straightforward task. Not only are there hidden expenses with these compensation plans (For example, what are the costs of the …