Stock options analyzed from three accounting perspectives: managerial, financial, and tax.

Publication: Management Accounting Quarterly

Publication Date: 22-MAR-03

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COPYRIGHT 2003 Institute of Management Accountants

CURRENTLY, STOCK-BASED COMPENSATION IS GOOD FOR COMPANIES. BUT THAT MAY CHANGE SOON.

Compensatory stock options (CSOs) make headlines daily these days even though this approach to compensation has been around for decades. In a debate over their relative costs and benefits, stakeholders inside the corporation are pitted against stakeholders outside the corporation. To help readers better understand why CSOs are under fire and why they are so attractive to issuing companies, we describe how they simultaneously align goals of three--often disparate--areas of corporate accounting: managerial, financial, and tax. This convergence contributed to the proliferation of CSOs in the expansive economy of the 1990s. We also consider the "dark side" of CSOs--their negative effects, real or perceived--and the array of new solutions proposed to account for them.

STOCK OPTIONS AS COMPENSATION

Corporations often use stock options to compensate their employees. While CSOs are quite complex, the idea behind them is simple. A compensatory stock option provides an employee with the right to purchase stock in his or her employer corporation at a specified purchase price (the exercise price) for a fixed period of time in the future. Historically, CSOs were granted only to top-level corporate executives, but in recent years employees at virtually all levels of the corporation have begun receiving this form of compensation.

Stock options are generally priced at the current market value of the underlying stock at the date of their issue. Most stock options have a vesting requirement--a specified length of employment before the options can be exercised. Cliff vesting refers to vesting that occurs at a single point in time. In contrast, graded vesting occurs gradually, with portions of the options vesting at intervals over a number of years. The exercise period is the stipulated time frame in which the employee can convert options to stock. This period does not commence until the employee is fully vested in the options.

CSOs are often issued in lieu of other forms of compensation. As such, they are presumed valuable. The initial value only grows, however, if the underlying stock appreciates during the period from the grant date to the exercise date. Consider the following example: Bob receives CSOs from his employer that permit him to purchase 1,000 shares of the company's stock subject to certain vesting requirements. At the grant date, the shares are trading for $4 per share. The exercise price on Bob's options is $4 per share. When Bob is fully vested in the CSOs, the company's shares are trading at $10 per share. If he exercises his shares at this point, Bob can purchase 1,000 shares with a market value of $10,000 for an investment of only $4,000. Of course, CSOs are not entirely without risk. Assume, instead, that when Bob is fully vested the company's shares are trading at $2 per share. If the share price remains below $4 during the exercise period, Bob would not exercise his options because he would be paying more than market price for the shares.

Compensatory stock options are typically granted in proportion to employees' earnings, with higher earners more likely to receive them. A survey by the U.S. Department of Labor's Bureau of Labor Statistics (BLS) of more than 2,000 corporations that granted options to their employees in 1999 found that more than 5% of all employees in publicly held corporations were granted CSOs. (1) Executives were almost four times more likely to receive CSOs than nonexecutives (20% vs. 5%). Within the nonexecutive salary group, employees earning at least $75,000 were about 12 times more likely to receive CSOs than employees earning less than $35,000 (27% vs. 2%). On average, stock options granted in 1999 were fully vested three years after the grant date. This average holds true for most employees when categorized by salary type. Yet almost 40% of CSOs granted to executives in 1999 vested in less than two years, while 27% of those granted to nonexecutives earning at least $75,000 vested in only two years.

AN INSIDE VIEW OF STOCK OPTIONS

It is rare that a single transaction can align the goals of managerial, financial, and tax accounting simultaneously. It appears that corporations have become well aware of this issue, which has led to the increased use of CSOs in recent years.

The Managerial Perspective. Investors purchase corporate stocks with the hope that the stocks will appreciate and increase their...

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