McIntire Investment Institute Fundamental Presented by Felise Agranoff. Expensing Stock Options. Current Briefing. What is a Stock Option? .
Presented by Felise Agranoff
1993: FASB issued exposure draft on stock options recommending that compensation stock options should be expensed.
Response: Strong opposition from businesses!!
SEC was weary about supporting FASB’s proposal due to effect on economy.
1994: FASB decides to encourage, instead of require, recognition of compensation costs.
APB Opinion No. 25: established in October 1972
Intrinsic Value Method of configuring compensation
=Market Price of Stock-Exercise Price of Stock at grant date
Result: Corporations do not recognize any compensation expense related to stock options because at grant date, market price and exercise price are usually the same
***This was the standard in place before FASB’s new recommendation in 1993***
Encourages, but does not require recognition of compensation cost for the fair value of stock-based compensation paid to employees for their services. SFAS 123 allows a choice between the intrinsic value method and the fair value method.
Fair Value Method: Configured using option pricing models such as Block and Scholes
(depends on risk-free interest rate and stock price variance)
A majority of corporations continue to use the intrinsic value method and the grant of employee stock options does not dilute reported earnings. They are reported in footnotes of financial statements. However, such options are deductible for tax purposes.
Buffet’s View:“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
Between 1991 and 2000, Microsoft issued 1.6 billion shares as
stock options and bought back 677 million shares
to partly offset the equity dilution. Microsoft was able to claim
a deduction on its tax return and therefore showed stock
options as a great expense for tax purposes, yet it made
no revelation to shareholders.
Chief executive said that Microsoft accepts the economic rationale for treating employee stock options as a regular business expense, though he indicated that the world's biggest software company was not willing to get ahead of its peers on the hotly debated issue.
How should the MII practices?
treat a corporation’s
treatment of options
in making our investment