What are Stock Options

Introduction

A lot of companies today have continue to offer their employees, their potential employees as well as other affiliated individuals, stock options as a way of recruiting, retaining and even motivating these particular individuals. During the last twenty years, stock options have increasingly become a major fringe benefit to employees who are salaried. In spite of some companies such as Dell, Amazon and Microsoft having recently reduced or abolished stock options for their employees, many other companies have continued with the practice which is common in the United States. As Albrecht, (1991) notes, the utilization of stock options in the technology industry has remained specifically widespread.

Stock option plans allows the employees to buy a company’s share. At times a company may provide a subsidized loan to its employees to facilitate them be able to purchase stock, or the company may match the amount of shares an employee buys by doubling the amount of the shares. However, other companies are providing discounted prices of shares to their employee which immediately translates to profit.

History of the Practice

Stock option has been a way of compensating employees for a number of years now, the practice dates back to 1972 when Accounting Principles Board issued its option number 25 calling for organizations to employ a system which has intrinsic value to use when valuing employees stock options given to them. Using the intrinsic value approaches employed at that period, organizations were issuing “ at the money” employee stock options not including any records for expenditure on the organization’s income statements, since the stock options were considered has not having any initial intrinsic value. Thus, though the system of not having records for expenses on stock option started way back, the number of stock options being given to employees was very little that a substantial number of employees ignored the stocks options. (Cuny and Jorion, 1995)
In 1993, Section 162M of the internal Revenue code section successfully put a ceiling to corporate top executive cash reward to a maximum of $1 million annually. During this period, the use of stock options as a way of employees’ compensation actually took off from here. This period coincided with ranging bullish market in stocks and equities particularly in technology-associated stocks, benefiting from fresh innovations and increased investor knowledge and demand. After this period, stock option become a common way of compensating employees, and apart from the top executives, other employees of different ranks were being awarded stock options as a way of attracting and motivating employees. (Cuny and Jorion, 1995)

Types of stock options

A small company may be able to grant various types of stock options to their employees, these types are outlined below.
• Incentive stock option: employees of the company simply pay taxes on these stock options during the time when they are selling them. Employees as well do qualify for a 20% long-standing investment gains tax supposing they sell their stock after a period of over two years after being granted the stock options.
• Non-qualified stock options: in this type, employees in general pay more taxes when they have these stocks. If the employees exercise the stock option, the employees are force to pay income tax arising from the price variation between the grant price of the share and the market price of the stock. The employers are the one who receive tax deduction arising from the difference. (Bowles, 2002)
• Restricted stock option: companies grant their employees a particular number of shares which the employees can be able to sell only after such a company achieves a particular goal or when a certain period of time set elapses. The employees are forced to pay for income tax arising from the earnings after the vesting of the stocks or when the stocks options have been issued. (Cuny and Jorion, 1995)

When to Use Stock Options

Employees require to be compensated for their performance in order to encourage them to keep up or improve on that performance. The moment the human resource establishes the performance of the worker, managers should reward to commensurate with the worker’s achievement. These will ensure maximum production and effectiveness of the worker; current compensation programs include a mix of basic pay, equities and variable pay (Cuny and Jorion, 1995). Many companies are currently using the stock option as a way of compensating and motivating their employees. A good example of such a company is the Starbucks. All Starbucks employees are known as partners no matter which job position the employee occupy. Each one of the partner (even part-timers) is entitled to get health care, take part in the Bean Stock program, and also get a free pound of coffee every week. In the Bean Stock program, Starbucks employees are given stock lower than the fair market value a number of times per year. At the same time the employees also take part in a 401(k) profit sharing plan.

Through buying the stock options in a company an employee get a chance to own part of the company. When the company thrives and its stock increases, the employees stand to benefit. As such the employee s bound to put in extra effort to make sure that the company succeeds so that he/she can also benefit. Thus, stock options as stated provide motivation to the employees. (Albrecht, 1991)

Behavioral implications

Stock options are supposed to create some implication for both the employers and also the employees. Creative owners of stock provides their employees with stock options as a way of incentive and to the employees so that the employees can be easily be retained at the company and only work for that company has the employees feels as being part and parcel of the company. Stock options have thus the ability to change the behavior of the employees of a company in a positive manner. The dividends which top executives and other employees receive do constitute the major part of compensating top executives. (Cox, and Rubenstein, 1979)

Current accounting practice and valuation of the options
Though, there are various different approaches which have been formulated to value tock options which are traded on the market, valuing the employees’ stock options has remained problematic to many. The problems related with valuing the employees’ stock options which are issued by companies that are privately owned are specifically delicate. However this paper will try and review some current accounting practices. (Carpenter, 1998)

Simple intrinsic value approaches might devalue the stock option in a situation where there is remarkable upside prospective but nearly no downside potential. Among the extensively accepted accounting practice is the Black-Scholes, (1973) option pricing model. This is a closed-form accounting model used to value those stock options which are traded in Europe. Among the most important assumptions held by this method is that stock option holders do have the capability of trading their stock in line with options which they were offered.

Other some companies have opposed the mandatory expenses by abolishing the usage of ESOs, some other companies for example Cisco have maintained ESO programs. Before 2005, Cisco Company employed the APB 25, adhering to FAS 123 stipulation in their 10-K plan. The table shows the net revenue for the company in the 2001-2003 financial years reported under FAS 123 accounting system. (Cenker and Monastra, 1991)

PARTICULARS 2001 2002 2003
Net Income (Loss) As Reported under FAS123 (1,014) 1,893 3,578
Option Compensation Expenses (net of tax) (1,691) (1,520) (1,259)
Net Income (loss) pro forma (FAS 123R) (2,705) 373 2,319

Critical assessment of the practice
The present situation of accounting regulations formulated for equity-founded compensation has to be very confusing. In a case where there is lack of compulsory expensing, accounting standard which is used by a lot of companies was known as Accounting Principles Board option 25 (APB, 25). The stated accounting standard came into implementation in 1972, just one year earlier than the formulation of Financial Accounting Standard Board as well as Black-Scholes accounting formula used to value traded stock options. (Black and Scholes, 1973; APB, 1972) The APB accounting standard allows companies to be able to account for their employees’ stock options through the use of “intrinsic value” (the disparity among the price of stock and that of option exercise. The common practice which makes options grant at the money results in an intrinsic value being zero value on the date of when the options where granted, for the purposes of accounting. Viewing this practice on its surface, it seems as misguided. However, ESOs do have value and that is why companies award these stock options to their employees. (Boudreaux, et al. 2000) Nonetheless, before the formulation of stock option pricing procedures, there existed substantial complexities on how to determine a “fair value”, for contingent compensation of offering sensible support for usage of the APB 25. Though, there have been efforts by the FASB over the years (1978-1984) to formulate an accounting practice for stock option compensation, by introducing the FAS 123 in the 1995, many companies have continued to use the APB 25 practice. (Cenker, and Monastra, 1991)

Different studies have indicated that the there have been a remarkable increase in amount of stock options being granted to employees over the years. Hall and Murphy (2003) expounds this point when they point out that an average sum of Employees’ stock options of 500 companies in which they researched had increased by more than tenfold going up to $238 down from $22 per each company. More than 90% of employees stock options were awarded to employees who were not top most five executives of companies, whereas the share amount of stock options which were being awarded to the CEO of companies had reduced from 7% to below 5%.

Basing on Boudreaux, et al (2000) the disagreements over compulsory expenses has continued to shift its location. Before FAS 123 R, the opponents of the practice have put a lot of stress on the problems of how to determine the “fair value” of stock option which are granted to employees. For instance, FAS 123 has stated in part 19 that “the fair value of stock option which is awarded by a particularly public entity will be approximated through the use of option pricing approach for instance by using the Black-Scholes model. FAS 123, for instance requires that ESO is has to be valued during that date on which they are being granted particularly in certain situations. The value of the stock option is not supposed to be changed for over the future. For example, loss of the time value as a result of early exercise need not to be shown in the companies’ financial reports which results in any overstatement resulting from fair value of ESO granted date compensation expenses.

Conclusion

Stock options allow the employees to buy a company’s share. Sometimes a company may provide a subsidized loan to its employees to facilitate them be able to purchase share, at times the company may match the amount of shares an employee buys by doubling the amount of the share. Nonetheless, other companies provide discounted prices of shares to their employee which immediately translates to profit. Over the years, stock option have increasingly become a way of compensating and motivating employees in many companies, both the top management and the junior employees. As such the use of stock options to motivate employees continue to increase in present times. Stock options can be accounted through different ways which have been formulated by different bodies. It is thus, clear that stock option is going to continue being adopted by many companies as a way to compensate and motivate and retain their employees in this competitive world.

Reference:
Albrecht, G (1991): Calculating the value of a closely held firm. Journal of Legal Economics 1(3): 1-6.

Black, F and Myron S. (1973): The pricing of options and corporate liabilities; Journal of Political Economy 81(3); 637.

Boudreaux, D, et al (2000): Analysis and valuation of closely held firms involved in business damage cases and application of certainty equivalence. Journal of Legal Economics 9(3); 5-18.

Bowles, T (2002): Valuing a small business: Implications of different income tax models; Journal of Legal Economics 11(3): 40-62

Carpenter, J (1998): The exercise and valuation of executive stock options. Journal of Financial Economics 48(2): 129-58.

Cenker, W and Monastra, C (1991): Business valuations; Constraints imposed by divorce. Journal of Legal Economics 1(3): 7-21.

Cox, J, and Rubenstein, M (1979): Option pricing; a simplified approach; Journal of Financial Economics 7(3); 259-63.

Cuny, C and Jorion, P (1995): Valuing executive stock options with an endogenous departure decision. Journal of Accounting and Economics 20(3); 190-203.

Emory, J (1985): The value of marketability as illustrated in initial public offerings of common stock January 1980 through June 1981. Business Valuation Review 4(3): 20-23

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