When ﬁrms grant shares to employees at less than market price, the difference between market price and issue price is treated under GAAP and IFRS as (deferred) compensation to employees and ultimately amortized as an expense to the income statement. This is appropriate accounting, for the discount from market value is compensation to employees and a loss of shareholder value. More frequently, though, shares are not granted to employees. Rather, stock options are granted and shares are issued later when the options are exercised. Unfortunately, GAAP and IFRS accounting do a poor job of reporting the effects of stock options on shareholder value.
Four events are involved in a stock option award: the grant of the option, the vesting of the option, the exercise of the option, and the lapse of the option. At the grant date, employees are awarded the right to exercise at an exercise price; the vesting date is the ﬁrst date at which they can exercise the option; the exercise date is the date on which they actually exercise at the exercise price; and the lapse date is the date on which the option lapses should the employee choose not to exercise. Clearly the employee exercises if the stock is “in the money” at exercise date, that is, if the market price is greater than the exercise price.
If the call option is granted in the money at grant date (with the exercise price set at less than the market price at grant date), accounting treats the difference between the market price and exercise price as compensation. That compensation is then recognized in the income statement over the vesting period, as in the case of a stock grant at less than market price. However, most options are granted “at the money,” with exercise price equal to the market price at grant date. As time elapses and the market price of the stock moves “into the money,” no additional compensation expense is recorded. Further, when options are indeed exercised, no compensation expense is recorded. You see on the ﬁrst line in Nike’s statement of equity that the amount received on exercise is recorded as issued shares, but, unlike the stock grants, the expense—the difference between the market price and the issue price— is not recorded.
The appropriate accounting is to record the issue of shares at market price and recognize the difference between the market price and issue price as an expense. In the absence of this accounting there is a hidden dirty-surplus expense. The expense is not merely recorded in equity rather than the income statement; it is not recorded at all. But there has been a distri- bution of wealth to employees and that distribution has come at the expense of the share- holders: The value of their shares must drop to reﬂect the dilution of their equity. GAAP ac- counting treats this transaction, which is both a ﬁnancing transaction—raising cash—and an operational transaction—paying employees—as if it is just a ﬁnancing transaction. This hidden dirty-surplus accounting creates a hidden expense. Box 9.1 calculates Nike’s loss from the exercise of stock options during 2010.
Some commentators argue that, because options are granted at the money, there is no expense. Employees—and particularly management, who beneﬁt most—say this adamantly.But there is no expense only if the options fail to move into the money. They also say that, as the exercise of options does not involve a cash payment by the ﬁrm, there is no expense. However, paying employees with stock options that are exercised substitutes for paying them with cash, and recording the expense is recording the cash-equivalent compensation: The ﬁrm is effectively issuing stock to employees at market price and giving them a cash amount equivalent to the difference between market and exercise prices to help pay for the stock. From a shareholder’s point of view, it makes no difference whether employees are paid with cash or with the value of the shares that shareholders have to give up; the shareholders are simply paying employees with their own paper rather than with cash. Recognizing this expense is at the heart of accrual accounting for shareholder value, for accrual accounting looks past cash ﬂows to value ﬂows; it sees an award of valuable stock for wages as no different from cash wages. If you are hesitant in viewing stock compensation as an expense, think of the case where a ﬁrm pays for all its operations—its materials, its advertising, its equipment—with stock options. (Indeed some sports stars have asked to be paid with stock options for promotions!) If the hidden expenses were not recognized, the income statement would have only revenues on it and no expenses. Stock options produce revenues and proﬁts for shareholders if they provide an incentive for employees and management. But GAAP accounting does not match the cost of the options against these revenues and proﬁts. Value added must be matched with value lost.
With the large growth in stock compensation in the 1990s, the hidden expense became quite signiﬁcant, particularly in the high-tech sector. The Financial Accounting Standards Board addressed the issue, but in writing Statement No. 123R came to an unsatisfactory conclusion. This statement requires compensation to be recognized at grant date at an amount equal to the value of the option, priced using option-pricing formulas. The compensationis then recognized in the income statement over a service period, usually the vesting period. The credit goes to shareholders’ equity, incorrectly as we have seen with Nike. The international accounting standard on the issue, IFRS 2, requires similar treatment. This treatment is called grant date accounting. But the granting of options yields an expense only in recognition of possible exercise. If the option lapses (because the stock does not go into the money), no expense is incurred, but the accounting maintains the expense. An expense is realized only if the option is exercised. The difference between the market price and exercise price at exercise date is the loss to shareholders. Recognizing this expense, as in Box 9.1, is called exercise date accounting. In 2010, Nike reported $159 million in before-tax stock option expense using grant date accounting. Box 9.1 calculates an expense of $161.1 million, be- fore tax, from the exercise of options during 2010. Now go to Accounting Clinic IV.
Signiﬁcantly, the Internal Revenue Service recognizes that an expense is incurred when options are exercised and gives the ﬁrm a tax deduction for it (if certain conditions are met). The ﬁrm books this tax beneﬁt to equity, often as an addition to the proceeds from the share issue. So the $379.6 million that Nike received from the exercise of stock options (in Exhibit 9.1) represents $321.1 million received from the share issue plus $58.5 million in tax beneﬁts. So, the accounting recognizes the tax beneﬁt of the expense, increasing equity, but not the associated expense!
Exhibit 9.2 presents a reformulated statement of shareholders’ equity for Nike that reports the loss from the exercise of stock options as part of comprehensive income. As GAAP records an expense based on grant date accounting, we have to be careful not to double count. So you see in the reformulated statement that the after-tax loss on exercise of stock options, $102.6 million, has been reduced by the $159 million that hasbeen recognized under grant-date accounting. That, of course, gets rid of the $159 million embarrassing “plug” in the reformulated statement in Exhibit 9.1. The difference between market price and exercise price, $161.1 million has been added to share issues to report them as if they were issued at market value (and thus add no value). Now the reformulated statement records transactions with shareholders at market value with any loss from issuing shares at less than market value appropriately recognized in comprehensive income. It’s all a bit messy to handle, but that’s what poor GAAP accounting leaves us with. The difference between the grant date and exercise date expenses can be quite large if options go well into the money after grant date.
The loss from exercise of options in the current period is a legitimate loss that should be reported. But when an investor buys a stock, he is concerned about how he could lose from these instruments in the future. Accordingly, valuation focuses on the expected losses from future exercise of options. This expected loss is referred to as the option overhang. It can be estimated as the loss incurred if outstanding options were exercised at the current market price. At the end of 2010, Nike had 36.0 million options outstanding with a weighted- average exercise price of $46.60. The closing market price for its shares at ﬁscal year end was $72.38. So the option overhang is estimated as follows (in millions):
This drag on the value of the shares amounts to $1.22 per share (with 484 million shares outstanding). Note that the liability for the expected loss is reduced by the expected tax beneﬁt on exercise. The measure of the option overhang here is a ﬂoor valuation; it should also include option value for the possibility it might increase.
Firms use options and warrants for other operating expenses beside wages. See Box 9.2.
ACCOUNTING FOR STOCK COMPENSATION
GAAP accounting for stock options in the United States employs grant-date accounting. The International Accounting Standards Board (IASB) also requires grant date accounting under IFRS 2.
Accounting Clinic IV leads you through grant- date accounting. Accounting Clinic IV also lays out exercise date accounting and takes you through the complete accounting that measures the effects of stock options on shareholders. Unearned compensation costs are recorded at grant date, and then recognized as expense in the income state- ment over the period when employee services are given. Accordingly, the compensation cost is matched against the revenues that the employees produce. Subsequent to grant date, further losses are recognized as options go into the money. Here are the steps to effect sound accrual accounting for stock options:
1. Recognize the option value at grant date as a contingent liability, along with a deferred (unearned) compensation asset. The two items can be netted on thebalance sheet. The option value at grant date is the amount recognized with grant-date accounting under FASB Statement No. 123R. The grant-date value given to employees is compensation, but it is contingent upon the options going into the money, so it is a contingent liability to issue shares. The deferred compensation asset is similar to that which arises from stock issues to employees at less than market value.
2. Amortize the deferred compensation over an employee service period, usually the vesting period.
3. Mark the contingent liability to market as options go into the money to capture the value of the option overhang, and recognize a corresponding unrealized loss from stock options.
4. Extinguish the liability against the share issue (at market value) at exercise date. If options are not exercised, extinguish the liability and recognize a windfall gain from stock options.
For more on appropriate exercise date accounting, go also to the Web page for this chapter.