Expensing Employee Stock Options: Is There A Better Way?

Prior to 2006, companies were not required to expense grants of employee stock options at all. Accounting rules issued under Financial Accounting Standard 123R now require companies to calculate a stock option's "fair value" on the date of grant. This value is calculated by using theoretical pricing models designed to value exchange traded options. After making reasonably adjusted assumptions to incorporate the differences between exchange traded options and employee stock options, the same models are used for the ESOs.

The "fair values" of the ESOs on the date they are granted to executives and employees are then expensed against earnings when the options vest to the grantees. (For a background reading, see our Employee Stock Options Tutorial.)

The Levin-McCain Attempt
In 2009, Senators Carl Levin and John McCain introduced a bill, the Ending Excessive Corporate Deductions for Stock Options Act, S. 1491. The bill was the product of an investigation conducted by the Permanent Subcommittee on Investigations, chaired by Levin, into the different book and tax reporting requirements for executive stock options. As the name suggests, the object of the bill is to reduce excessive tax deductions to companies for the "expenses" paid to executives and employees for their employee stock options grants. "Eliminating unwarranted and excess stock option deductions would likely produce as much as $5 to $10 billion annually, and perhaps as much as $15 billion, in additional corporate tax revenues that we can't afford to lose," said Levin.

But is there a better way of expensing employee stock options to accomplish the expressed objects of the bill?

Preliminaries
There is much discussion these days about abuses of equity compensation, especially employee stock options and hybrids like cash settled options, SARs, etc. Some advocate the idea that the actual expenses charged against income for tax purposes not be greater than the expenses charged against earnings. This is what the Levin- McCain bill was about.

Some also claim that there should be an expense against earnings and taxes in the early years starting immediately after the grant, regardless whether the ESOs are subsequently exercised or not. (To learn more, see Get The Most Out Of Employee Stock Options.)

Here's a solution:

First, State the Objectives:

To make the amount that is expensed against earnings equal to the amount expensed against income for tax purposes (i.e. over the life of any option from grant day to exercise or forfeiture or expiration).
Calculate expenses against earnings, and expenses against income for taxes at grant day and not wait for the exercise of the options. This would make the liability that the company assumes by granting the ESOs deductible against earning and taxes at the time the liability is assumed (i.e. on grant day).
Have the compensation income accrue to the grantees upon exercise as it is today with no change.
Create a standard transparent method of dealing with options grants for earnings and tax purposes.
To have a uniform method of calculating the "fair values" at grant.

This can be done by calculating the value of the ESOs on the day of grant and expensing it against earnings and income tax on the day of grant. But, if the options are later exercised, then the intrinsic value (i.e. the difference between the exercise price and the market price of the stock) on the day of exercise becomes the final expense against earnings and taxes. Any amounts expensed at grant that were greater than the intrinsic value upon exercise are to be lowered to the intrinsic value. Any amounts expensed at grant that were less than the intrinsic value upon exercise will be raised up to the intrinsic value.

Whenever the options are forfeited or the options expire out of the money, the expensed value at grant will be canceled and there will be no expense against earnings or income tax for those options.

This can be achieved the following way. Use the Black Scholes model to calculate the "true value" of the options at grant days using an expected expiration date of four years from the grant day, and a volatility equal to the average volatility over the past 12 months. The assumed interest rate is whatever the rate is on four year Treasury bonds and the assumed dividend is the amount presently being paid by the company. (To learn more, see ESOs: Using The Black-Scholes Model.)

There should be no discretion in the assumptions and the method used to calculate the "true value." The assumptions are to be standard for all ESOs granted. Here's an example:

Assume:

That XYZ Inc. is trading at 165.
That an employee is granted ESOs to purchase 1,000 shares of the stock with a maximum contractual expiration date of 10 years from the grant with annual vesting of 250 options each year for four years.
That the exercise price of the ESOs is 165

In the case of XYZ, we assume a volatility of .38 for the past 12 months and four years expected time to expiration day for our "true value" calculation purpose. The interest is 3% and there is no dividend paid. It is not our objective to be perfect in the initial expensed value because the exact expensed amount will be the intrinsic values (if any) expensed against earnings and taxes when the ESOs are exercised.

Our objective is to use a standard transparent expensing method resulting in a standard accurate expensed amount against earnings and against income for taxes.

Example A:
The grant day value for the ESOs to purchase 1,000 shares of XYZ would be $55,000. The $55,000 would be an expense against earnings and income for taxes on the day of grant.

If the employee terminated after slightly more than two years, and was not vested on 50% of the options, those were canceled and there would be no expenses for these forfeited ESOs. The $27,500 expenses for the granted but forfeited ESOs would be reversed. If the stock was $250 when the employee terminated and exercised the 500 vested ESOs, the company would have total expenses for the exercised options of $42,500. Therefore, since the expenses were originally $55,000, the company's expenses were lowered to $42,500.

Example B:
Assume that the XYZ stock finished at $120 after 10 years and the employee got nothing for his vested ESOs. The $55,000 expense would be reversed for earnings and tax purposes by the company. The reversal would take place on the day of expiration, or when the ESOs were forfeited.

Example C:
Assume the stock was trading at $300 in nine years and the employee was still employed. He exercised all his options. The intrinsic value would be $135,000 and the entire expense against earnings and taxes would be $135,000. Since $55,000 was already expensed, there would be an additional $80,000 expensed for earnings and taxes on the day of exercise.

The Bottom Line
With this plan, the expense against taxable income for the company equals the expenses against earnings, when all is said and done, and this amount equals the compensation income to the employee/grantee.

Company Tax Deduction = Company Expense Against Earnings = Employee Income

The expense against taxable income and earnings taken at grant day is just a temporary expense, which is changed to the intrinsic value when the exercise is made or recaptured by the company when the ESOs are forfeited or expire unexercised. So the company does not have to wait for tax credits or expenses against earnings. (For more, read ESOs: Accounting For Employee Stock Options.)