Employee Incentive Stock Options: To Be Expensed or Not to Be, that is Not the Question

Abstract

Many companies have granted large numbers of employee incentive stock options, and there is intense debate as to how they should be reported on financial statements. According to the mission statements of the regulatory organizations responsible for financial statements, the primary purpose of financial reporting is to help investors evaluate a company so that capital can be efficiently allocated. I show that to accomplish this purpose, investors need financial statements that: (1) report the estimated aggregate market value of all outstanding stock options as a balance sheet line-item separate from common equity accounts, similar to the way preferred stock is reported; (2) update the estimated aggregate market value of the stock options (i.e., "mark to market" the stock options) each reporting period; and (3) reduce stockholders' common equity by the amount that the market value of outstanding options increases during the reporting period (or increase stockholders' equity by the amount that the stock options' aggregate market value decreases). This change in stockholders' equity could be accomplished either indirectly (via an expense on the income statement that flows through to retained earnings) or directly (without affecting reported net income, in the same way that an unrealized change in value due to a foreign currency translation adjustment is reported). Although either method is satisfactory for purposes of valuation, reporting ISO grants as an operating expense on the income statement actually complicates the analysis for investors, since they must "undo" this non-cash charge when estimating cash flows. Thus, investors do not need option grants to be reported as an expense, if the estimated aggregate market value of option grants is reported as a separate balance sheet line-item and is updated each reporting period.

Keywords: employee stock options, expensing stock options, compensation, reporting stock options, corporate valuation

JEL Classification: G12, G18, G30, G38, M41, M44, J33