A Proposal for Expensing Employee Compensatory Stock Options for Financial Reporting Purposes

Peter Hancock, Roberto G. Mendoza and Robert Merton

Journal of Applied Corporate Finance, 2005, vol. 17, issue 3, 95-101

Abstract: This article presents an accounting approach for employee stock options based on the insight that the currentperiod compensation expense should reflect only that part of the option value that is earned independent of the obligation of continued employment. Given that the maturity of vested options is typically shortened to 90 days when an employee resigns or is terminated, this method views the employee as owning a 90‐day option (even if the stated maturity of the option is ten years) and earning a 90‐day extension to that option each quarter as a result of the employee's continued employment. In the case of vested options, the compensation expense in each quarterly accounting period is thus the value of the 90‐day extension of the option's maturity. There is no option expense in the quarter when the option is either exercised or expires. In the case of unvested options, the expected option value at vesting should be estimated quarterly starting at the time of grant and the corresponding estimated expense should be revised and allocated as a pro rata accrual each quarter over the vesting period. The cumulative expense over the entire vesting period will equal the fair market value of the option at its vesting date. Besides reflecting the economics of the exchange of value for labor involved in stock option grants, this approach has a number of practical advantages: • The 90‐day maturity permits the use of publicly traded options to determine fair market value and makes Black‐Scholes and other (lattice) pricing models more reliable. • The shortened maturity eliminates the need to adjust for early exercise or employee attrition. • Consistent application should lead to a greater degree of comparability in option valuation and expense allocation among companies (including those that use restricted stock instead of options).

Date: 2005
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