1. ESOs: Introduction
  2. ESOs: Accounting For Employee Stock Options
  3. ESOs: Using the Black-Scholes Model
  4. ESOs: Using the Binomial Model
  5. ESOs: Dilution - Part 1
  6. ESOs: Dilution - Part 2
  7. ESOs: Conclusion

By David Harper

Relevance above Reliability
We will not revisit the heated debate over whether companies should "expense" employee stock options. However, we should establish two things. First, the experts at the Financial Accounting Standards Board (FASB) have wanted to require options expensing since around the early 1990s. Despite political pressure, expensing became more or less inevitable when the International Accounting Board (IASB) required it because of the deliberate push for convergence between U.S. and international accounting standards. (For related reading, see The Controversy Over Option Expensing.)

Second, among the arguments there is a legitimate debate concerning the two primary qualities of accounting information: relevance and reliability. Financial statements exhibit the standard of relevance when they include all material costs incurred by the company - and nobody seriously denies that options are a cost. Reported costs in financial statements achieve the standard of reliability when they are measured in an unbiased and accurate manner.

These two qualities of relevance and reliability often clash in the accounting framework. For example, real estate is carried at historical cost because historical cost is more reliable (but less relevant) than market value - that is, we can measure with reliability how much was spent to acquire the property. Opponents of expensing prioritize reliability, insisting that option costs cannot be measured with consistent accuracy. FASB wants to prioritize relevance, believing that being approximately correct in capturing a cost is more important/correct than being precisely wrong in omitting it altogether.

Disclosure Required But Not Recognition … For Now
As of March 2004, the current rule (FAS 123) requires "disclosure but not recognition". This means that options cost estimates must be disclosed as a footnote, but they do not have to be recognized as an expense on the income statement, where they would reduce reported profit (earnings or net income). This means that most companies actually report four earnings per share (EPS) numbers - unless they voluntarily elect to recognize options as hundreds have already done:

On the Income Statement: 1. Basic EPS
2. Diluted EPS
In a Footnote: 1. Pro Forma Basic EPS
2. Pro Forma Diluted EPS

Diluted EPS Captures Some Options - Those That Are "Old" and "In the Money"
A key challenge in computing EPS is potential dilution. Specifically, what do we do with outstanding but un-exercised options, "old" options granted in previous years that can easily be converted into common shares at any time? (This applies to not only stock options, but also convertible debt and some derivatives.) Diluted EPS tries to capture this potential dilution by use of the treasury-stock method illustrated below. Our hypothetical company has 100,000 common shares outstanding, but also has 10,000 outstanding options that are all in the money. That is, they were granted with a $7 exercise price but the stock has since risen to $20:

Basic EPS (net income / common shares) is simple: $300,000 / 100,000 = $3 per share. Diluted EPS uses the treasury-stock method to answer the following question: hypothetically, how many common shares would be outstanding if all in-the-money options were exercised today? In the example discussed above, the exercise alone would add 10,000 common shares to the base. However, the simulated exercise would provide the company with extra cash: exercise proceeds of $7 per option, plus a tax benefit. The tax benefit is real cash because the company gets to reduce its taxable income by the options gain - in this case, $13 per option exercised. Why? Because the IRS is going to collect taxes from the options holders who will pay ordinary income tax on the same gain. (Please note the tax benefit refers to non-qualified stock options. So-called incentive stock options (ISOs) may not be tax deductible for the company, but fewer than 20% of options granted are ISOs.)

Let's see how 100,000 common shares become 103,900 diluted shares under the treasury-stock method, which, remember, is based on a simulated exercise. We assume the exercise of 10,000 in-the-money options; this itself adds 10,000 common shares to the base. But the company gets back exercise proceeds of $70,000 ($7 exercise price per option) and a cash tax benefit of $52,000 ($13 gain x 40% tax rate = $5.20 per option). That is a whopping $12.20 cash rebate, so to speak, per option for a total rebate of $122,000. To complete the simulation, we assume all of the extra money is used to buy back shares. At the current price of $20 per share, the company buys back 6,100 shares.

In summary, the conversion of 10,000 options creates only 3,900 net additional shares (10,000 options converted minus 6,100 buyback shares). Here is the actual formula, where ($M) = current market price, ($E) = exercise price, (T%) = tax rate and (N) = number of options exercised:

Pro Forma EPS Captures the "New" Options Granted During the Year
We have reviewed how diluted EPS captures the effect of outstanding or old in-the-money options granted in previous years. But what do we do with options granted in the current fiscal year that have zero intrinsic value (that is, assuming the exercise price equals the stock price), but are costly nonetheless because they have time value? The answer is that we use an options-pricing model to estimate a cost to create a non-cash expense that reduces reported net income. Whereas the treasury-stock method increases the denominator of the EPS ratio by adding shares, pro forma expensing reduces the numerator of EPS. (You can see how expensing does not double count as some have suggested: diluted EPS incorporates old options grants while pro forma expensing incorporates new grants.)

We review the two leading models, Black-Scholes and binomial, in the next two installments of this series, but their effect is usually to produce a fair value estimate of cost that is anywhere between 20% and 50% of the stock price. While the proposed accounting rule requiring expensing is very detailed, the headline is "fair value on the grant date". This means that FASB wants to require companies to estimate the option's fair value at the time of grant and record ("recognize") that expense on the income statement. Consider the illustration below with the same hypothetical company we looked at above:

(1) Diluted EPS is based on dividing adjusted net income of $290,000 into a diluted share base of 103,900 shares. However, under pro forma, the diluted share base can be different. See our technical note below for further details.

First, we can see that we still have common shares and diluted shares, where diluted shares simulate the exercise of previously granted options. Second, we have further assumed that 5,000 options have been granted in the current year. Let's assume our model estimates that they are worth 40% of the $20 stock price, or $8 per option. The total expense is therefore $40,000. Third, since our options happen to cliff vest in four years, we will amortize the expense over the next four years. This is accounting's matching principle in action: the idea is that our employee will be providing services over the vesting period, so the expense can be spread over that period. (Although we have not illustrated it, companies are allowed to reduce the expense in anticipation of option forfeitures due to employee terminations. For example, a company could predict that 20% of options granted will be forfeited and reduce the expense accordingly.)

Our current annual expense for the options grant is $10,000, the first 25% of the $40,000 expense. Our adjusted net income is therefore $290,000. We divide this into both common shares and diluted shares to produce the second set of pro forma EPS numbers. These must be disclosed in a footnote, and will very likely require recognition (in the body of the income statement) for fiscal years that start after Dec 15, 2004.

A Final Technical Note for the Brave
There is a technicality that deserves some mention: we used the same diluted share base for both diluted EPS calculations (reported diluted EPS and pro forma diluted EPS). Technically, under pro forma diluted ESP (item iv on the above financial report), the share base is further increased by the number of shares that could be purchased with the "un-amortized compensation expense" (that is, in addition to exercise proceeds and the tax benefit). Therefore, in the first year, as only $10,000 of the $40,000 option expense has been charged, the other $30,000 hypothetically could repurchase an additional 1,500 shares ($30,000 / $20). This - in the first year - produces a total number of diluted shares of 105,400 and diluted EPS of $2.75. But in the forth year, all else being equal, the $2.79 above would be correct as we would have already finished expensing the $40,000. Remember, this only applies to the pro forma diluted EPS where we are expensing options in the numerator!

Expensing options is merely a best-efforts attempt to estimate options cost. Proponents are right to say that options are a cost, and counting something is better than counting nothing. But they cannot claim expense estimates are accurate. Consider our company above. What if the stock dove to $6 next year and stayed there? Then the options would be entirely worthless, and our expense estimates would turn out to be significantly overstated while our EPS would be understated. Conversely, if the stock did better than expected, our EPS numbers would've been overstated because our expense would've turned out to be understated.

ESOs: Using the Black-Scholes Model

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