Accounting for Employee Stock Options

Transcription

1 Accounting for Employee Stock Options Arnaud van Oers June 2001 Post Graduate Program Chartered Controller University of Maastricht University of Amsterdam Washington University in St. Louis

2 Preface Annual reports are prepared to inform internal and external stakeholders (especially shareholders) about the well being of the company. The auditor clarifies that the financial statement gives a true and fair view of the financial position of the company. In the annual accounts all financial transactions should be recorded. The application of accounting rules gives a lot of possibilities for interpretation, especially accounting for accruals and provisions. This is where subjective norms enter into the field of accounting, which is perceived to be a relative abstract science that leaves no room for discussion. In this thesis I will elaborate on the possibilities of interpretation and discussion on applied accounting rules in the respect of Employee Stock Options. This thesis is written as part of my study at the University of Maastricht and Amsterdam in cooperation with the Olin School of Business of Washington University in St. Louis. In the wide variety of subjects taught during the course, this thesis is written under the supervision of Mr. Langendijk, responsible for the course topic Financial Accounting. 1

3 Contents PREFACE... 1 CONTENTS INTRODUCTION AWARDING EMPLOYEE STOCK OPTIONS PRO S CON S INTERNATIONAL AND NATIONAL ACCOUNTING STANDARDS INTERNATIONAL ACCOUNTING STANDARDS (IAS) UNITED STATES (US GAAP) UNITED KINGDOM (UK GAAP) NETHERLANDS (DUTCH GAAP) SUMMARY CONCLUSION VALUATION OF AN EMPLOYEE STOCK OPTION MARKET VALUE OF AN EMPLOYEE STOCK OPTION INTRINSIC VALUE HISTORICAL COST METHOD FORECAST GROWTH METHOD THE FAIR VALUE MODEL LITERATURE CONCLUSION RECOGNITION DATE OF AN EMPLOYEE STOCK OPTION IS AN OPTION EQUITY OR DEBT? GRANT DATE SERVICE DATE VESTING DATE EXERCISE DATE CONCLUSION

4 6 G4+1 POSITION PAPER: ACCOUNTING FOR SHARE-BASED PAYMENTS AN EMPLOYEE STOCK OPTION IS EQUITY AN OPTION PRICING MODEL SHOULD BE USED TO VALUE AN EMPLOYEE STOCK OPTION VESTING DATE SHOULD BE USED AS RECOGNITION DATE COMMENT LETTERS ON THE DISCUSSION PAPER EMPLOYEE STOCK OPTIONS IN THE ANNUAL REPORTS REPORTING EMPLOYEE STOCK OPTIONS ACCORDING TO IAS REPORTING EMPLOYEE STOCK OPTIONS ACCORDING TO US GAAP REPORTING EMPLOYEE STOCK OPTIONS ACCORDING TO UK GAAP REPORTING EMPLOYEE STOCK OPTIONS ACCORDING TO DUTCH GAAP CONCLUSION CONCLUSION LITERATURE APPENDIX A THE VALUE OF EMPLOYEE STOCK OPTIONS APPENDIX B OVERVIEW OF COMPANIES APPLYING IAS APPENDIX C OVERVIEW OF COMPANIES APPLYING US GAAP APPENDIX D OVERVIEW OF COMPANIES APPLYING UK GAAP APPENDIX E OVERVIEW OF COMPANIES APPLYING DUTCH GAAP

5 1 Introduction Employee Stock Options are call-options on the shares of the company where the employee is working. Stock options are often only rewarded to the management, therefore Employee Stock Options are also known as Management Stock Options. A stock option gives the employee the right to purchase company stock at a future date, at a price established when the option was granted. Stock options are intended to motivate the executive to manage the company in line with the interests of the shareholder, enhancing the value of the stock option. A stock award creates a close affinity of interests between the management group and the shareholders. For incentive and tax reasons, the option price should be higher than the current price. However, there is evidence 1 that most stock options are issued at the money; that is with an exercise price equal to the existing market price. But options with exercise prices far in- or out-ofthe money do also exist. An Employee Stock Option is a combination between a European option and an American option. Until the date that the employee is allowed to exercise the stock option it is a European option, because it is not transferable and not exercisable. From the date on which the owner is allowed to exercise the option it becomes an American option. Formulation of the problem Accounting for Employee Stock Options is not fully evolved yet. National accounting boards as well as the International Accounting Standards Board are reviewing the accounting rules on Employee Stock Options, especially the presentation in the profit and loss account. In this paper I want to make clear what problems arise in Accounting for Employee Stock Options and try to find a solution to these problems. 1 Lewellen, Park and Ro, 1995, pp

6 Research questions In this thesis I deal with the question How to account for Employee Stock Options? Two relative important parameters are (1) the valuation and (2) the date of recognition of Employee Stock Options. Therefore the sub-questions are (1) How to value Employee Stock Options? and (2) When to recognize Employee Stock Options in the annual accounts? Methodology To answer these questions I have studied the International Accounting Standards and three national accounting rules (chapter three). Furthermore, I have done a literature study (chapters four and five) and a field study (chapter seven) on the Employee Stock Options. The structure of this paper is as follows, in chapter two the advantages and disadvantages of Employee Stock Options are described. In chapter three the emphasis is on accounting for Employee Stock Options according to the International Accounting Standard (IAS) and three different national General Accepted Accounting Principles (GAAP), respectively US GAAP, UK GAAP and Dutch GAAP. In chapters four and five the theory on the valuation and the recognition date of Employee Stock Options is presented and discussed. In the year 2000, the International Accounting Standards Committee (IASC) addressed the valuation and recognition problem and appointed a Working Group, the G4+1 Group. The G4+1 Group issued a discussion paper. This paper Accounting for share-based payments is discussed in chapter six. For the practical part of this paper I have investigated twenty annual reports, five companies reporting according to IAS and five companies that applied respectively US GAAP, UK GAAP and Dutch GAAP. These annual reports are assessed on presentation and disclosures made on accounting for Employee Stock Options. The result of this assessment is presented in chapter seven. Finally, in chapter eight the conclusions of this paper are summarized. 5

7 Limitations and restrictions There are many more questions on Employee Stock Options then answers and also many more questions than can be dealt with in this paper. For example, in this paper the relationship between the value of the Employee Stock Options and the performance of the employee will not be discussed. Another related item that will not be discussed is the minimum number of options that is necessary to motivate and satisfy the employee, or the maximum number of options to award in order to keep the employee employed and to prevent the company for financial retirement of good employees. 6

8 2 Awarding Employee Stock options 2.1 Pro s Agent Principal dilemma The agent principal dilemma is synonymous for the relationship between the shareholder and the manager, with the shareholder being the principal (the owner of the company) and the manager being the agent for the shareholder. The agent does have other interests than the principal. The manager is working for the owner of the company, while the manager does have more information about the company than the principal. This dilemma is minimized if the manager has common interests with the principal. Therefore the employees are given Employee Stock Options to let the employees have interests in line with the interests of the shareholder. Time Frame Difference The management can be focused on short-term results rather than long-term profitability because of the annual awarded bonuses. With stock options, executives are presumed to attempt to influence long-term share price performance rather than short-term profits. Minimizing Risk Averse behavior The management has fewer possibilities of portfolio management and risk pooling. For being employed, the management is heavily dependent on the well being of the company they are working for. The main target for the management is continuity. The management is also more aware of not performing below the market average than out-performing the market. By outperforming the market, the targets for next year will be higher and the bonus will be harder to earn. An option has no downside loss (since the executive does not actually own the stock) and unlimited upside potential. Therefore, executives may be encouraged to reduce risk-averse behavior that would otherwise accompany their ownership of stock to undertake riskier projects with higher payoffs. 7

9 Attracting Staff For start-up companies it is very hard to attract qualified employees, and if they can be attracted the personnel costs are relatively high, because of the risk of continuity the employee has. With awarding the employees with Employee Stock Options, the employees can grow with the company and the awards can be higher than being employed with a traditional company. The employee being awarded with stock options has the potential benefits for the risk undertaken. With awarding stock options it is possible for start-ups to attract qualified staff. Holding Staff Employee Options have a vesting period. When the options are awarded, the options are not directly exercisable. Before the options can be exercised, the employee has to be employed by the company for a certain period (mostly three years). This limitation of the Employee Stock Option ensures the company of retaining qualified staff within the company. 2.2 Con s Market Circumstances The share price and subsequently the option price is dependent on more factors than the management performance only. In situations of an overall growing market the option can become much more valuable although the management is not outperforming the market. The other way around, the management that has outperformed a bear market may not create value for the options. Accumulating effect Because Employee Stock Options are awarded every year, the motivational effect of the options will decline over the years. At the time that the options awarded come to expiration, the options become a yearly increasing cost element. Because every year the awarded number of options have to increase to keep the employees satisfied, the Employee Stock Options become an increasing cost component for the company. 8

10 Immunization effect The Employee Stock Options are implemented as an incentive for the management to perform better and to be paid extra by exercising the options. After a couple of years of collecting the exercise payments, the employee becomes immune to the payment and counts for it as a part of the annual rewards. At the time the options are out-of-the-money at exercise date, the employees will recognize the stock options as a dissatisfier instead of a satisfier. Independence of management The Employee Stock Options have as an advantage the possibility to contract employees for a longer period, because of the vesting period. On the other hand, after a few years of collecting exercise payments, the employee becomes financially independent and has no need to work anymore or at least for less hours a week. The cashing of options enables the management an earlier financial retirement. Conclusion The Employee Stock Option has advantages to focus the management on the interest of the shareholder. With the Employee Stock Option it seems possible to create a less risk averse, long term thinking, shareholder related interested employee, but as described there are also disadvantages and the shareholder has to pay the price for the alignment. If the shareholder can be informed properly about the price (s)he pays for the Employee Stock Option will be discussed in this paper. 9

11 3 International and National Accounting Standards Internationally there is material difference in reporting on Employee Stock Options. Four different methods of accounting are described. First is described accounting according to the International Accounting Standards (IAS). These standards do not have any legal right, but give guidelines for different national accounting standards. The national accounting board can implement these guidelines separately. Besides the IAS, General Accepted Accounting Principles (GAAP) in the United States of America (US GAAP), the United Kingdom (UK GAAP) and the Netherlands (Dutch GAAP) are described. 3.1 International Accounting Standards (IAS) In IAS there is one relevant standard on Employee Stock Options. The standard is IAS 19 and there is an interpretation from the Standing Interpretations Committee (SIC): Final Interpretation SIC IAS 19 Employee Benefits Under IAS 19 paragraph 144 and further, the Equity Compensation Benefits are described. Paragraph 144 emphasizes that under IAS employee share options are equity. It is presented as follows: Equity compensation benefits include benefits is such forms as: (a) shares, share options, and other equity instruments, issued to its employees at less than the fair value at which those instruments would be issued to a third party; and (b) cash payments, the amount of which will depend on the future market price of the reporting enterprise s shares IAS does not give standards on recognition or measurement requirements of Employee Stock Options, but only prescribes the disclosure regulation. 10

12 3.1.2 Disclosure under IAS 19 The disclosures under IAS 19 are extensive and described in paragraph 147 and148. Under IAS 19 the following information shall be disclosed: 147. An enterprise should disclose: a. The nature and terms (including any vesting provision) of equity compensation plans b. The accounting policy for equity compensation plans c. The amounts recognized in the financial statements for equity compensation plans. d. The number and terms (including, where applicable, dividend and voting rights, conversion rights, exercise dates, exercise prices and expiry dates) of the enterprise s own equity compensation plans (and, in the case of share options, by employees) at the beginning and end of the period. The extent to which employees entitlements to those instruments are vested at the beginning and end of the period should be specified. e. The number and terms (including, where applicable, dividend and voting rights, conversion rights, exercise dates, exercise prices and expiry dates) of equity financial instruments issued by the enterprise to equity compensation plans or to employees (or of the enterprise s own equity financial instruments distributed by equity compensation plans to employees) during the period and the fair value of any consideration received from equity compensation plans or the employees. f. The number, exercise dates and exercise prices of share options exercised under equity compensation plans during the period. g. The number of share options held by equity compensation plans, or held by employees under such plans, that lapsed during the period; and h. The amount, and principal terms, of any loans or guarantees granted by the reporting enterprise to, or on behalf of, equity compensation plans An enterprise should also disclose: a. The fair value, at the beginning and the end of the period, of the enterprise s own equity financial instruments (other than share options) held by equity compensation plans; and b. The fair value, at the date of issue, of the enterprise s own equity financial instruments (other than share options) issued by the enterprise to equity compensation plans or to employees, or by equity compensation plans to employees, during the period. If it is not practicable to determine the fair value of the equity financial instruments (other than share options), that fact should be disclosed SIC 16 Share Capital Required Own Equity Instruments (Treasury Shares) Treasury shares are described in SIC 16. Treasury shares are of relevance to Employee Stock Options in case a company buys shares in the market to hedge the possible obligation of awarded Employee Stock Options in order to prevent for dilution. The SIC indicates that treasury shares should be presented in the balance sheet as a deduction from equity, and the acquisition of treasury shares should be presented in the financial statements as a change in equity. Additionally, no gain or loss should be recognized in the income statement on the sale, issuance, or cancellation of treasury shares, and consideration received should be presented in the financial statements as a change in equity

13 3.2 United States (US GAAP) Under US GAAP there is a choice of two methods of accounting for Employee Stock Option plans. The first option is reporting according to the Financial Accounting Standards Board (FASB) Statement 123 (fair value method). The second option is reporting according to the Accounting Principles Board (APB) Opinion 25 (intrinsic value method). If FAS 123 is chosen then a company may not choose to revert to APB 25 at a later date. Entities electing to remain with the accounting in Opinion 25 must make pro forma disclosures of net income and, if presented, earnings per share, as if the fair value based method of accounting defined in FAS Statement 123 had been applied APB 25 Accounting for Stock Issued to Employees Under APB Opinion 25 (released 1972) the compensation expense is measured as the access of the market price over the option price on the measurement date. The measurement date is the first date on which both are known (a) the number of shares that an individual employee is entitled to receive and (b) the stock option price or purchase price if any. Commonly this will be the grant date, but if later, then the cost should be measured over the service period using the market price at the end of each intervening period. The costs recognized have to be charged to the expense over the periods in which the employee performs the related services Disclosure under APB 25 Disclosure is made of the status of the option plan at the end of the period, including: - Number of shares under option - Number of shares over which options are currently exercisable - Exercise price - Number of shares exercised during the period, including the exercise price - Pro forma disclosures of net income and earnings per share, as if the fair value based method of accounting defined in statement 123 had been applied. Since the release of APB 25 questions have surfaced about its applications and different practices have developed. The FASB reconsideration of the stock compensation issue culminated in the issuance of FAS Statement

14 3.2.3 FAS Statement 123 Accounting for Stock-Based Compensation Under FAS Statement 123 (released 1995) the compensation cost of the Employee Stock Options is based on the fair value of the option at the date of grant. FAS 123 also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by APB Opinion No. 25. In FAS 123 the valuation of stock options for employee services is described as follows: 1. The fair value of a stock option (or its equivalents) of a publicly traded company shall be estimated using an option pricing model (Black-Scholes or a-binomial model). This model should take into account: - The stock price at grant date - The exercise price - The expected lifetime of the option - The volatility of the underlying stock - The expected dividends on the stock - The risk free interest rate over the expected lifetime of the option The option is valued at the date of grant and is not subsequently revisited. 2. The fair value of a stock option of a non-publicly-traded company shall be estimated using an option model, but it need not consider the expected volatility of its stock prices. Excluding volatility in estimating an option s value is an amount commonly termed minimum value. The fair value of an option estimated at the grant date is not subsequently adjusted for changes in the price of the underlying stock or its volatility, the lifetime of the option, dividends on the stock, or the risk-free interest rate. FAS 123, Accounting for Stock based compensation, encourages the recognition of cost for the fair value of stock-based compensation paid to employees, but does not require to do so. Under both methods of accounting, companies may buy their own shares as treasury stock to cover their positions with respect to the Employee Stock Options without affecting the accounting for the stock options itself, but note that shares must be shown as a deduction from equity (purchase of own shares). 13

15 3.2.4 Disclosure under SFAS 123 Under SFAS 123 the following information shall be disclosed: 1. The number and weighted average exercise price of options, a) those outstanding at the beginning of the year, b) those outstanding at the end of the year, c) those that may be exercised at the end of the year, d) those granted, exercised, forfeited, or expired during the year. 2. The weighted average grant-date fair value of options granted during the year. 3. The number and weighted average grant-date fair value of equity instruments other than options granted during the year. 4. A description of the method and significant assumptions during the year to estimate the fair value of options, including the following weighted average information of: a) risk-free interest rate. b) expected life. c) expected volatility. d) expected dividends. 5. Total compensation cost recognized. 6. Terms of significant modifications of outstanding awards. 7. For options outstanding at the latest year-end date, the range of exercise prices and the weighted average remaining contractual life shall be disclosed Although FAS123 describes detailed information to be disclosed, the accounting regulations have not been fully implemented throughout all listed companies in the United States, as concluded in the research done by Tang and Conroy 3. The reduction in net income and Earnings per Share (EPS) were not reported due to immateriality. But the authors expect that the majority of the nondisclosing companies will be doing so soon, because the reduction in net income and EPS will become more substantial each year. It needs to be taken into account that at the time Tang and Conroy wrote this article, FAS 123 was implemented with a phase in period, where compensation costs are recognized over the vesting period. 3 Tang and Conroy,

16 3.3 United Kingdom (UK GAAP) Under UK GAAP there is one article to be referred to: UITF 17 The Urgent Issues Task Force (UITF) issued on the 19th October 2000 a revised abstract 17 that supersedes the abstract of UITF 17 Employee share schemes The cost of options awarded to employees is recognized immediately under UITF 17, if they are unconditional on performance criteria (unless clearly unrelated to past performance for example on initial recruitment). If the award of options is conditional upon future performance criteria, the cost should be recognized over the period to which the employee s service relates. In order for share options to be treated consistently with share performance plans, the UITF concluded that as a minimum cost the undiscounted intrinsic value at the date of grant of the option should be recognized as a cash cost. This cash cost should be charged in the profit and loss account. The cost to be accrued for in the profit and loss account must match the period to which the performance criteria relate. The cost should be based on a reasonable expectation of the extent that the performance criteria will be met. Where the company holds shares (in substance) in connection with an option scheme the shares are shown as an asset and their cost may affect the cost of the scheme. The valuation of the stock option is not as detailed as under FASB 123. UITF is most related to the valuation of stock compensation plans and less to the stock option compensation plans. Employee Stock Ownership Plans (ESOP) are described in UITF Abstract 13. Disclosures to be made about management rewards under UK GAAP are described in the paragraphs relating to Directors. Other related disclosures are given for SAYE schemes (Save as you Earn) Disclosure under UITF 17 The disclosures to be made for stock option plans are: - details of number of shares that may be issued under options to subscribe - service date, vesting date and exercise date - exercise price 15

17 3.4 Netherlands (Dutch GAAP) The Netherlands follows the IAS in reporting on Employee benefits, but IAS is not explicit with how to report on Employee Stock Options. The Dutch GAAP (Richtlijnen voor de Jaarverslaggeving) uses the disclosure model. Of importance are guideline 204 Eigen Vermogen (equity) and guideline 271 Aandelenoptieregelingen voor personeel (Employee Stock Options) Disclosures under Dutch GAAP In guideline 204 are described disclosures that have to be made on conditional and unconditional awarded stock options outstanding at the end of the financial year. Disclosures have to be made for every board member separately and for the other employees as a whole. The disclosures to be made are: - Number of options awarded per category - Number of shares and the nominal value of the shares - The exercise price - Expiration date - The most important conditions - If there are specific finance arrangements - Other data that can be of interest to value the options Furthermore the company has to disclose: - Number of options exercised during the year - The exercise price - The number of shares bought in the market - The number of new shares issued Separately the company has to give information on: - How many new options are issued, with the number of underlying shares, the exercise price and the expiration date. In guideline 271 the disclosures are extended with the regulation that if awarded options are in the money, the company has to declare the difference between exercise price and stock price. The difference should be reported in the profit and loss account as a salary component. Taxation on Employee Stock Options paid by the company should also be reported as salary costs. 16

18 The company has to disclose the hedge policy according to the Employee Stock Options, either the company buys shares in the market, buys call options or issues new shares. On balance date, the awarded but not hedged position must be reported and if stocks are bought in the market to cover the option position, the transaction price for the purchase should be reported. The Dutch GAAP does not oblige but recommends that transactions in equity should be reported under other reserves and not as additional paid-in capital. 17

19 3.5 Summary In the matrix below there is a comparison made on the valuation method, the disclosure date and the disclosures to be made under IAS, US GAAP, UK GAAP and Dutch GAAP. IAS US GAAP UK GAAP Dutch GAAP APB 25 FAS 123 UITF 17 Valuation method Fair value X X Intrinsic value X X X Market value Historical cost Forecast growth Recognition date Grant date Service date X X Vesting date Exercise date X X X Disclosures to be made Fair value X X Intrinsic value X X X Number of shares under option X X X X X Number of options granted X X X X X Number of options exercisable X X X Number of options exercised X X X X X Options outstanding beginning of the year X X X X X Options outstanding end of the year X X X X X Number of shares issued X Stock price at grant date X Number of shares bought in the market X Exercise date X X X X X Exercise price X X X X X Expected lifetime of the options X Expiry date X X X X X Expected volatility of the underlying stock X Expected dividends X Risk free interest rate X Nature and Terms X X X X Accounting Policy X X X X Dilution effect Costs charged to P&L 18

20 3.6 Conclusion As discussed in this chapter there are material differences between reporting according to IAS and the applicable rules in the different countries. Only IAS and FAS 123 use the fair value calculation on Employee Stock Options and also the disclosures to be made differ significantly. Dutch GAAP is said to follow IAS but it can be concluded that only FAS 123 is strict following IAS and that APB 25, UK GAAP and Dutch GAAP have great similarities in accounting on Employee Stock Options. 19

21 4 Valuation of an Employee Stock Option To value the Employee Stock Option, different valuation methods can be applied. In this chapter, five valuation methods will be discussed with the advantages and disadvantages of each method. The methods described are the market value, the intrinsic value, the forecast growth model value, the historical cost method and the fair value method. 4.1 Market Value of an Employee Stock Option If comparable options are traded on the open option market, the market valuation method of an Employee Stock Option would be the best value measurement, however an Employee Stock Option is never available in the market. Should an Adjusted Market Value be used? Pro s If the market value of an Employee Stock Option can be determined, this would be the best available alternative to value the Employee Stock Option. An adjustment for non-transferability and delayed exercise possibility could also be taken into account to provide a reasonable basis for the actual value of the option. Cons The characteristics of a non-traded option are too different from traded options, that the market value of a non-traded option is not comparable with the value of a traded option with some similar properties. The exercise price and date can be equal, the volatility can be equal, but the differences between the non-traded and the traded option are significant. The main differences are non-transferability and time to exercise. The non-traded option should be valued being a European option, where the traded option should be valued as being an American option with a possibility to exercise from day one onwards. 20

22 4.2 Intrinsic Value The intrinsic value of the option is the difference between market value of the stock and the exercise price of the option. Pro s The intrinsic value is easy to determine. The intrinsic value is known as the minimum value of the option. It can be determined at any point of time, without an arbitrary component. The intrinsic value can easily be calculated as being the difference between exercise price minus current stock price with a minimum of zero. At the grant date, as well as on any other date, the valuation at intrinsic value can be done without arbitrariness. Cons The value of the exercise price of the option minus the current stock price is not equal to the present value of the option. The time value of the option is not taken into account, while the timevalue of an option is very important. Another aspect is the dividend to be paid on the stock, these are not included in the option price and therefore the intrinsic value is not an appropriate method of calculating the value of the Employee Stock Option. 4.3 Historical Cost Method To ensure that the company can fulfil the promised obligations at expiration date, the company can buy shares in the market. The price paid for the shares is known as the historical cost price. The purchase of its own shares (held in a trust) can also been done before the options are awarded. Pro s The company has coverage for the shares to be delivered at a later date. The costs are fixed and the exposure to the company is minimized. 21

23 Cons The historical cost of the shares especially when they are repurchased before the grant date has no relation with the value of the option. If the shares were bought in the past at a much lower rate, the calculated value of the option has no relation with the current value of the option at grant date. Furthermore, dividend payments are not taken into account when the historical cost method is used. A discount should be made for the undistributed dividend payments and a mark-up should be made for the time value of money. This would give too much complication to calculate a reliable and realistic value of the option 4.4 Forecast Growth Method The forecast growth model calculates the value of the option on the forecast of the future stock price. The forecast is based on the assumed annual growth rates in the stock price. Pro s The calculation of the Forecast Growth Model with a binomial chart is a valuation on the basis of a European option, which has similarities with the Employee Stock Options, because of the delayed exercise possibility. The traded options can give the market expectation of the future stock price. Cons The future growth rate of stock prices is not available. Insiders of the company have to make an expectation of the growth rate, while the same employees are awarded with the option on the stock price. The future stock price can not be forecasted. 22

24 4.5 The Fair Value Model The fair value would be the market value of an Employee Stock Options, but because of the absence of the market price an alternative is needed to calculate the fair value. One method of determining the fair value is valuing the payments that would have been made to the employees if no options were awarded. If there were no options awarded to the employee, the employee should have been compensated with other emoluments. The valuation of the other emoluments or cash equivalents could be an indication of the value of the awarded options. This does not seem to be an appropriate method and consequently the only method left to determine fair value is a theoretical approach. A model can be used to value the Employee Stock Option. Financial analysts often use the Black and Scholes model to determine the value of options. Further details on the Black and Scholes model are described in appendix A. Pro s The use of a model is objective. A model can be improved over time and therefore can be adjusted in the future without changing accounting rules. A model can be translated into a spreadsheet and can easily calculate the value of the option. Cons A model will only be a representation of reality and will never meet the reality. Depending on the input, this representation can be better or worse. The model mostly used in the financial world is the Black and Scholes option model, but as described before, this model has its limitations in representing the real world, but is (at this time) a generally accepted method of calculating the value of an option. 23

25 4.6 Literature Having discussed the advantages and disadvantage of the different ways of valuing the Employee Stock Option it is clear that it is hard to determine the best way of valuing. In the literature different approaches are offended and defended. Samuels and Lymer 4 distinguish four valuation methods: market price, intrinsic value, forecast growth and the mathematical option pricing method (Black and Scholes). According to their article, the intrinsic value method should be used at exercise date, because no estimations have to be made, where is referred to a letter of Coopers and Lybrand stating the selection of assumptions has a greater impact on value estimates than the choice of option-pricing models 5. Egginton, Forker and Grout 6 follow the disclosure model and conclude that the company should disclose a set of information, comparable to the inputs of the Black and Scholes model, in order to facilitate investors and auditors to calculate the value of the Employee Stock Options themselves. Concluding the different regulations, theories and practices, an Option Pricing model seems to be generally accepted to estimate the fair value of the Employee Stock Options. Knowing the imperfections of the model, an adjusted model should be developed, whereby the shortcomings of the model are minimized. Tang and Conroy 7 researched practices on corporate disclosures on FAS 123. The finding is that of 150 selected companies 135 companies offered Employee Stock Options. From this group 93 companies disclosed details about valuation. All 93 companies reported according to APB 25 and all 93 companies used the Black and Scholes option model to calculate the fair value of the options. 4 Samuels and Lymer, 1996, pp Coopers and Lybrand, Egginton, Forker and Grout, 1993, pp Tang and Conroy,

26 4.7 Conclusion Neither the National Accounting Boards nor the literature consensus has agreed upon the valuation method of Employee Stock Options. The Financial Accounting Standards Board encourages using FAS 123, which means valuing the Employee Stock Option at fair value using an option-pricing model, but at the same time, the FASB also allows to continue to measure according to APB opinion 25 using the intrinsic value based method. UITF prescribes the use of the non-discounted intrinsic value of share option, in order that share options are treated consistently with share performance plans. IAS and Dutch GAAP do not describe the method to calculate the value of the Employee Stock Options, it is mentioned that fair value should be used if that is possible to determine, otherwise it should be disclosed that it is not practical. So far the international accounting rules do not give answer to the question on how to value the Employee Stock Options. In the literature Samuels and Lymer argue for non valuation other than the intrinsic value method at exercise date where Egginton, Forker and Grout prefer an option pricing model, where the Black and Scholes model has to be modified for the shortcomings in valuing Employee Stock Options. Tang and Conroy concluded that despite the extensive description on how to value Employee Stock Options under FAS 123, not all companies report according to the regulations, particularly because of the immateriality. In my opinion the information to the shareholder should be as clear as possible and the valuation method of Employee Stock Options should be equal. Although the Black and Scholes model has its disadvantages, it is a comparable formula for different companies. The similarities can be increased if the inputs for the model are better described. The volatility should be calculated over a fixed record period, for example the last six months or year of the company stock. The risk free interest rate used in the calculation should also be equal for all companies. A rate determined by the Federal Reserve Bank could be used or the interest rate on 15 year government bonds. Using fixed or well described inputs in the Black and Scholes model where possible minimizes the freedom of calculating the price of the Employee Stock Options. Therefore, I support the idea of Egginton, Forker and Grout that a further improvement of the Black and Scholes model is recommended to minimize the shortcomings of the model in calculating the value of Employee Stock Options. 25

27 5 Recognition date of an Employee Stock Option The recognition of an Employee Stock Option in the accounts can be at different moments in time, depending on the accounting rules and/or theoretical approach. To determine which entries have to be made in the accounts it first needs to be discussed whether the Employee Stock Options are equity or debt. If this question is answered the possible recognition dates are described. The recognition dates described in this chapter are grant date, service date, vesting date and exercise date. 5.1 Is an option Equity or Debt? The issue arises if the option is equity or debt for the company. Because once an equity instrument has been issued it is not subsequently remeasured in the financial statements of the issuer, in contrast with the same instrument being held at a reporting company. If options would be classified as debt, the valuation comes into question because debt is remeasured at the end of the year and equity is not. Remeasuring the option at the end of an accounting year would give disputes on valuation especially when the option is (close to or) at the money and the stock price is very volatile. This can have a reasonable impact on the valuation of the options and therefore to the financial statements. It is most likely that options are equity, because share options do not give rise to transfer economic benefits to another party, like cash or other assets of the entity. If Employee Stock Options are debt, then other options should be recognized as debt as well, which means remeasuring all other forms of share subscription rights on the exercise date. Ordinary shares for example are classified as equity on the basis that the entity is not compelled to transfer assets to the shareholder until some formal act has occurred, such as the declaration of a dividend. The same obligation does not hold true for an option and therefore it can be concluded that an Employee Stock Option is equity. Thus the problem of valuation at the end of the accounting year does not rise. 26

28 5.2 Grant date The grant date is the date that the company makes a commitment to the employee, that under certain conditions, a particular number of options will be awarded. The employer and employee enter into a contract at grant date. The conditions that are part of the contract influence the value of the option. The conditions also influence to what extent the options should be recognized, for example the period that the options are under restrictions and are not exercisable. If the options can be exercised from the grant date, there is no possibility to defend that the costs should not be recognized. The longer the service period, the more unlikely it is that the option will be exercised and the lower the price is. If the exercise price is very high it is defendable that the option will not be exercised in the future, thus it is defendable that no costs are reported yet. Conditions on employee stock option can be: The employee has to remain employed by the company until date vesting date Profit targets or certain growth levels that have to be met over a certain period of time. Pro s Recording should be done on grant date because from this time on the company has an obligation to issue the shares at exercise date, as long as the employee fulfills his or her obligations. The decision to exercise or not is out of the company s hand. When the option contract has a value to the employee, it can be seen as compensation to the employee for the services provided by this employee. If the options were not awarded, the employee would have received another compensation, like a cash payment. If a cash payment is made, it is reported in the income statement as a cost. By awarding options instead of cash, there should also be the same charge to the income statement. Otherwise, it seems that options are an excellent opportunity to reward employees without reporting costs. The market perception still is that free lunches are not available. 27

29 Cons Why should a company account for costs, if costs are not made? By accounting for options on grant date, the costs for options are recorded while it is not sure that these costs are ever really made. The conditions to award the options are not fulfilled yet. The service is not delivered yet and therefore costs should not be reported at this time. If the option has to be accounted for on grant date, it should be possible to value the option. The uncertainties about the value of the options are enormous, especially if options are awarded with an exercise price higher than the actual market price. An out-of-the-money option has a value that is heavily determined by the volatility of the underlying stock and the time to expiration. The valuation can differ heavily at the grant date and it is not sure if the option will ever be exercised, therefore, a valuation later in time makes more sense, because the value can be determined more precisely and less arbitrary. Journal entries If Employee Stock Options are recognized on grant date, an entry into the accounts have to be made in order to show costs in the Profit and Loss account (P&L). The entry to report cost is: Dr Salary costs Cr Stock options to be awarded If the stock options are not bought in the market, the valuation of the balance item Stock options to be awarded is of relevance in presenting a true and fair value of the company. The valuation methods discussed in chapter 4 can be applied if allowed by the national GAAP. If stock options are bought in the market, the relevance of valuation is very low, because of the hedged position. At the time of the purchase of the options the entry is: Dr Stock options Cr Cash 28

30 The balance sheet (BS) items stock options and Stock options to be awarded should balance. Because of this balance, revaluation of stock options (asset) is not necessary to give a true and fair value of the company. The valuation can not have a significant impact on ratios, as there is the debt/equity ratio. Instead of options, the company can also buy stocks in the market, the reasoning is the same, the company is hedging the risk of an increasing stock price. When the options are not bought in the market, the company has an exposure in the stock price of its own company. At the time it becomes clear that the stock options will not come to exercise, because the employee doesn t fulfill his obligations, the entry into the account is: Dr Stock options to be awarded Cr Salary costs This can influence the salary costs in years subsequent to the year in which the options were awarded. If the stock options are bought in the market, they can also be sold in the market. At the expiration date the stock options have to be delivered or an equivalent amount in cash. If the options are bought in the market, the options are transferred to the employee and the entry into the accounts of the company is: Dr Stock options to be awarded Cr Stock options If the options were not bought in the market at grant date, the options have to be bought at this time or an equivalent amount in cash has to be paid to the employee. The entry is: Dr Stock options to be awarded Cr Cash If the company doesn t want to pay by cash but prefers to issue new shares, the employee pays for the shares at the exercise price and the company issues new shares. The entry is: Dr Cash Dr Stock options to be awarded Cr Un-issued stock Cr Stock premium (Agio) 29

31 The stock premium is the difference between the exercise price and the nominal value of the stock, where the nominal value is normally much lower than the exercise price. Here dilution is used to pay off the debt to the employee. 5.3 Service date The service date is the date on which the total services are fulfilled and/or all conditions are met. From the service date onwards, the employee is unconditionally entitled to the option but this does not mean that the employee has the right to exercise the option from the service date. Service date accounting is aiming for the matching principle. Costs have to be recognized over the time that the service is delivered to the company. Pro s On the grant date, there is not a right of the employee to the options, because the performance has not been delivered. On the vesting date the employee has the unconditional right to the option. This right is gained during the service period, and not from one day to the other. Therefore, the service date is preferable to the vesting date, as a matter of the matching principle. Costs are recognized in the time that services have been delivered to the company. The option plan is part of the remuneration to the employees in return for the delivered service by the employees. Depending on the expired service time and the time to the vesting date, a proportional obligation should be accounted for because the company has received the services of the employee. Cons The service period is inappropriate to measure the value of the awarded option and to account for the option, because the value of half an option can not be measured. If the employee has still not fulfilled all his obligations during the service period, the employee has no right at this time. The employee has only fulfilled the obligations to the company if he or she is still employed by the company on the vesting date. As long as all conditions are not met, there is no obligation of the company to the employee and the company should not account for the option only partially serviced. The service date is also inappropriate because a financial instrument is issued on a particular date and cannot be issued progressively over time. 30

32 As mentioned at the grant date, the valuation can differ heavily during the service period and after the service date and it is not sure whether the option will ever be exercised. Therefore, a valuation later in time makes more sense, because the value can be determined more precisely and less arbitrarily. Journal entries During the service period the costs are recognized in the accounts. This can be done in three ways: 1. Buying the options at the grant date and recognizing the costs during the service period, 2. Buying the options in the market during the service period or 3. Recognizing the costs during the service period and taking a provision for the costs at the exercise date. 1. The journal entry when options are bought at the grant date is: Dr Options Cr Cash Recognizing the costs during the service period, the repeating journal entry is: Dr Salary costs Cr Stock options to be awarded At the end of the service period the account Options needs to balance with the account Stock options to be awarded. Upon exercise the journal entry is: Dr Stock options to be awarded Cr Options 2. The journal entries when options are bought in the market during the service period are: Dr Options Cr Cash Dr Cr Salary costs Stock options to be awarded At exercise date the entry is equal to the entry when options are bought at the grant date. 31