Accounting in the new Market
these restrictions should result in a price discount which should be factored into the pricing model, but because there's no market standard, FAS 123 doesn't allow companies to estimate what the discount should be. (The Financial Accounting Standards Board does define a calculation for expected pre-vesting forfeitures.) 9
Alan Greenspan commented on this subject in a recent speech addressing the options controversy: “Some have argued against option expensing on the grounds that the Black-Scholes formula, the prevailing means of estimating option expense, is approximate. It is. But, ..., so is a good deal of all other earnings estimation.” 5
The argument concerning the accuracy of the current pricing models is valid, but it still doesn’t prove that options shouldn’t be expensed.
III. Financially accurate without expensing
Some opponents contend that since expensing is required in the footnotes, investors can flip back and subtract the options expense from the earnings statement. The availability of this information makes it unnecessary to require expensing in the body of the statement. Opponents also believe that markets are generally efficient and that share prices reflect available information, so it really doesn't matter if a firm deducts the options expense from earnings as long as the options are disclosed-which they are. 3
One study that supports this belief is a study by the Federal Reserve that points out there is a self-correcting mechanism with stock options as they affect share prices. The Fed study found that the more options a company grants the less it pays out in dividends, which reduces share prices. Money that would otherwise be used for dividends is used to repurchase shares for exercised options, which prevents dilution. Other studies have found that granting options to senior executives improves their performance, thereby raising profits and shareholder value. Ultimately, in a rational market, stock prices should already reflect the impact of stock options, causing them to be priced correctly. 6
The assumptions in the previous paragraphs are (1) the market is rational and (2) investors are savvy enough to pick up on information contained in the footnotes. These are dangerous assumptions when you the average investor considering floating money into a stock.
Calculating the expense
To comply with the Statement of Financial Accounting Standards(SFAS) No. 123 “Accounting for Stock-Based Compensation”, companies offering stock based compensation plans must determine the fair value of the options. The Financial Accounting Standards Board (FASB) then gives companies a choice concerning reporting of options. They may use either the fair value method and recognize expenses in the income statement, or the intrinsic value method and disclose in the notes the pro forma impact on net income and earnings per share (if presented) as if the fair value method had been used. 1 Both methods are explained below.
I. Intrinsic value