Accounting for Employee Stock Options

• Published in: Accounting horizons 2004-06, Vol.18 (2), p.135-156
• Main Authors: Kirschenheiter, Michael, Mathur, Rohit, Thomas, Jacob K
• Format: Article
• Language: English
• Subjects: Accounting; Book value; Business accounting; Cash flow forecasting; Cash flow statements; Cost estimates; Debates; Deferred income taxes; Dilution; Dividends; Earnings per share; Employees; Equity; Equity capital; Fair value; FASB statements; Financial accounting standards; Financial performance; Financial reporting; Financial statements; Grants; Liability; Net income; Options on stocks; Present value; Profitability; Profits; SFAS 123; SFAS 128; SFAS 95; Stock options; Stock rights; Stockholders; Studies
• ISSN: 0888-7993; 1558-7975
• DOI: 10.2308/acch.2004.18.2.135

Accounting for employee stock options is affected by whether outstanding options are viewed as equity or liabilities. The common perception is that the FASB's recommended treatment (per SFAS No. 123), which is based on the options-as-equity view, results in representative financial statements. We argue that this treatment distorts performance measures for three reasons. First, the deferred taxes associated with nonqualified options should also be included as equity, but are not. Second, since unexpected share price changes affect optionholders and equityholders differently, combining their interests provides an average earnings effect that is not representative for either group. We show that efforts to isolate the interests of common stockholders via diluted earning per share calculations (per SFAS No. 128) are inherently incapable of identifying wealth transfers between stockholders and optionholders. Finally, projections of future cash flow statements prepared under SFAS No. 95 overstate cash flows to current equityholders by the pretax value of projected option grants. We show that these distortions can be avoided simply by accounting for options as liabilities at grant and thereafter recognizing changes in option values (similar to the accounting for stock appreciation rights). Our analysis of stock option accounting leads to two, more general implications: (1) all securities other than common shares should be treated as liabilities, thereby simplifying the equity versus liability distinction, and (2) these liabilities should be recorded at fair values, thereby obviating the need to consider earnings dilution.