The Theories of Accounting for Stock Options

Introduction

The Employee’s Stock option is an option that an employee has given by the company as a part of the employee’s remuneration package. The objective of this measure is usually to enhance the performance of the employee in a way that will boost the stock price of the company. This stock option needs to be accounted using different approaches. This paper provides learners with a chance to have an opportunity on the accounting for stock options. A stock option can be accounted applying various ways. It is worth noting that the theories of accounting arrive at different methods to account for stock options in an organization. This paper describes the new learning that has occurred in the adult education class. The activities and instances in the class that facilitated learning have also been described in this term paper. Relevant applications to the field of stock options have been made and analyzed critically. The debating of the theories of accounting has remained the key issue in this paper.

Main Issues in the Theories of Accounting for Stock Options

Companies usually have to stock for the options that they issue to their employees in respect of the accounting rules that come with the financial Accounting Standards Board (ASB). The lessons learnt in this unit clearly show that the Financial Accounting Standards Board (FASB) has to account for these options that the employees get. The employees who get these stock options usually get an added advantage in their job. In this module, the learners have successfully learnt the methods of accounting for stock options. These methods used by employees vary differently depending on the performance of the organizations they are working. These methods include: the Intrinsic value, Fair value, and the Lattice Model (Sweeney, 1960).

Intrinsic Value

Long before 1995, the intrinsic value was recognized as a method of accounting for stock options. This theory was taught in the class as the oldest theory of accounting for stock options. This method entails the use of the intrinsic value of the company at the time it was granted to value the stocks of the company. The difference between the stock market prices at the time when the company gets granted the stock market and the exercise price that the employee could use to buy the stock applying the option is the intrinsic value. The stock options value is the difference between the stock market price and the option exercise price. It can be observed in the cases when the stock market price is higher than the exercise market price. Since most companies usually have the stock market price equal to the exercise price as equal values, the companies using this method to account for stock options did not necessarily have to account for them as compensation expenses. To enhance the understanding of this theoretical concern of accounting for employees’ stock options, the class instructor used various relevant charts and tables (Ruud, 2004). The use of power point presentations was hugely influential to illustrate the performance of this theory to account for stock options. Also, we visited a company where we learnt a lot about the accounting for stock options and the use of this method to account for the same ones. This theory can be used to account for stock options by companies that are particularly keen on keeping clear records of their initial stock option expenses and the amount saved by the employees.

Fair Value

It is a method of accounting for stock options that was ensued after the FASB had changed its policies and approach for accounting for stock options after the shortcomings of the intrinsic theory of accounting had been considered. The new learning that has occurred in class teaching the theories of accounting for stock options clearly indicates that companies should use the fair value approach as a valuing option in their exercises of accounting for stock options. The fair value is used to value stock options in a company based on extremely many factors that usually determine the company’s underlying value. In this case, a company has to expense for the option grants that have a basis on the fair value of the options that are expected to vest on the date of a grant. Also, this approach enhances a company to use the Black-scholes or binomial option pricing models to come up with the fair value of the options. Also, this approach recommends that the users of the intrinsic approach had to value their stock options using the fair value approach to compare the performance of a company when these two different approaches are applied. This is because these approaches did not get developed at the same time in history. Therefore, it is unquestionably vivid and clear that the theories of accounting learnt in class have to be time conscious (Stickney et al., 2009). The following happens because the theories used by companies to account for stock options vary at different times in history.

To enhance a proper understanding of this theory of accounting, the module instructor gave use several illustrations that helped to understand the performance of the company under the Intrinsic approach, and the Fair value approach was used to account for stock options in the two different companies. The use of graphs and pie charts was immensely valuable in class since it helped to understand the illustrations presented, comparing the performance of the companies when the two different theories were applied. The knowledge of this theory can be crucial in managing a company. In the future, if one gets challenged by accounting for stock options given to employees in a company, the use of this theory can be tremendously valuable.

Lattice Model

In the field of adult education, the Lattice model has also been taught as a theory of accounting for stock options in the companies. According to my understanding of this theory, it ensued as a result of irregularities that were found in the considerable American companies. This made the FASB change the approaches it had been using to account for stock options. Afterwards, the FASB made a mandatory provision that all companies should expense their stock options. The Lattice model is another way of arriving at the option values of a company. This model uses the basic principles of the Black-scholes option pricing model. Also, it has adjustments that make it integrate so easily with the real world circumstances. The Lattice model is even in a position to incorporate inputs, such as the changes that occur in price stock volatility, as well as in their stock options terms and conditions. To enhance the understanding of this theory of accounting for stock options, the instructor used power point presentations, charts, graphs, and pie charts. This showed clearly that the performance of companies with the use of the three theories of accounting for stock options (Nikolai, Bazley, & Jones 2009).

The Lattice model turned out to be the most convenient and topical ways accounting for the stock options that employee get from the companies. The following made this theory be understood extremely well by the students. The knowledge of this theory is r relevant in the field of adult education since it develops their skills to manage companies and assess the performance of different companies with regard to accounting for stock options and the different methods used to handle the same.

Class Activities or Incidents that Facilitated Learning and Understanding

The class visited some prominent companies where we were able to get a better understanding of the topic. In one of the companies, we were informed that the outcry that regards corporate governance and accountability is an interest renewed in requiring the expensing of the stock options. The company manager informed that the information tends to be shared by the International Accounting Standards Board (IASB) and some voices that are powerful on the Capitol Hill. We came to learn that many corporate entities usually choose to expense theory options, where the tide appears to be shifting towards the actual expense–based approach. It is an approach that would eventually become mandatory.

Learning the Stock Option Share Equivalent

During the class trip, we learnt some few things about the company. The company manager told that there was held the stock option share equivalents proposal. He informed that the company held annual general meetings where every shareholder is supposed to attend in order to learn about the progress of the company. In these meetings, the treasurer would read the figures to the shareholders and a date when the divisions would be made. As the grant date, the future dilutive that got estimated of the new grant options should be reflected as a transaction of capital and should be recorded as a diluted weighted average shares increase. This decreases the earning per share. The increase in diluted weighted that gets averaged shares outstanding can be usually defined as the Stock Option Share Equivalent (SOSE) (Noreen, 1976). We were informed that the Stock Option Share Equivalent that should be added to diluted weighted average shares outstanding is determined by the division of the options fair value on the grant date. This is done as per an acceptable valuation method like Black-Scholes by the current share price of the company.

The company manager also informed us that the Stock Option Share Equivalent must be always identified separately in the reconciliation of the company’s diluted weighted average common shares outstanding. In this particular company, the calculation of the common market equivalent that gets done using the treasury stock method continues. The Stock Option Share Equivalent gets reduced for any dilution that occurs usually under the treasury stock method that is done on a quarterly basis. We learnt that, even if the Stock Option Share Equivalent balance gets reduced to zero, the dilution usually continues to get captured through the computation of the common stock that is equivalent under the treasury stock method. This is done until the options get forfeited, exercised, expire or cancelled. If there tends to be a balance of Stock Option Share Equivalent at the time the options that tend to be usually related appear to be no longer exercisable the get usually removed from the diluted weighted shares that are averagely outstanding. It happens if the actual dilution seemed to be less than the estimated dilution (Siegel & Shim, 2006).

The rationale for these rules was exceedingly easy. This is because since there were no cash changes in hand when the grant was made, giving out a stock option cannot be an economically significant transaction. The Black-Scholes formula publication in 1973 influenced a massive boom in the market for trade options that were public. The company followed the FASB policy, which initiated a review of stock option accounting. It recommended the companies to report concerning the options granted costs. The companies were also required to determine their fair market value by using the option pricing models. The new standard was seen as a compromise that reflected intense lobbying by the businessmen and politicians against mandatory reporting.

Effects of Stock Option Share Equivalent

The Stock Option Share Equivalent had some effects on the company’s revenue, some of which are beneficial. By using the Stock Option Share Equivalent, there was a reduction of earnings per each share that accompanies each a grant. There is no phase-in period that can be required. This is because the Stock Option Share Equivalent for all its prospective awards gets a full recognition on the grant date. When the Stock Option Share Equivalent is compared with the EPS overtime, it will have a sharper accuracy in the representation of a company’s performance. The granting of options gets reflected immediately on the earnings calculation per every share presented in every company’s income statement. This is done irrespective of the type, whether it gets fixed, performance based, or discounted. By using the Stock Option Share Equivalent, the impact of the grants that are dilutive will not get double counted in the denominator and the numerator of earnings per each calculation of a share. Each company will be in a good position to recognize the dilutive impact of the option grants on the award. This is without respect to the vesting of the company’s awards that will allow for the comparability of financial statements. The net income of each company will closely match the cash flow earnings in a continuous manner (Wallace, 2007).

Usually, this allows a better comparability between the companies and transparency in any financial reporting. The analysts will be in a much better position to track a company’s grant rate. It is usually the percentage of the fully diluted outstanding shares that happen due to options granted in the year. The companies will be always in a position to balance the awards appropriately that usually delivers the current incentive compensation. This usually is done with those that can be capable of providing some potential accumulations of capital.

Illustrations

The Stock Option Share Equivalent always has an approach to accounting for the stock options calls for an increase in the diluted shares calculations. This is done at the time of reflecting of the grants estimated of dilutive effect of options of the granted. By using the Stock Option Share Equivalent approach, the stock option grant effect will be reflected as transaction capital and stock option grants. This will lead to having an immediate dilutive impact on the EPS. The Stock Option Share Equivalent proposal calls to get added to the diluted shares outstanding at the grant time. The Stock Option Share Equivalent number is calculated by having a division of the fair value of the grant per an acceptable valuation method. It is done with having an input for relevant items, such as the current stock price, exercise price, risk free rate, stock price vitality, and stated maturity (Walker, 2004).

Conclusion

It is evident that the theories of accounting usually arrive at different methods in accounting for stock options in an organization. Companies aim at opting for the best way to handle and use theories to have a better management in the stock options. The main aim of an employee stock option is to have alignments in the interests of the option holder with those of the shareholders. An assumption that can be made with the Stock Option Share Equivalent is that a company will not buy back its stock prior to the options getting exercised. We make an assumption that the treasury stock method can be used by the stakeholders to buy stocks whose shares gets issued. It is clear that the Stock Option Share Equivalent has some effects on the company’s running, which sees the running of the company become smooth. This shows that, in order for the company to maximize on the profit and still value its customers, it should have a good and understandable way to manage its stock.