Professor Paul Zarowin - NYU Stern School of Business
Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes
Executive Compensation - Stock Options
 events and dates: grant 7exercise/lapse/reprice
 terms and definitions
 Intrinsic Value Method APB #25
 Fair Value Method SFAS #123
 footnote disclosure and pro-forma NI
 EPS and dilution
Executive Compensation - Stock Options
Executive compensation via stock options relates to owners= equity thru the potential dilution
that occurs if the options are exercised (see the dilution effects of options described in the
module on EPS), since exercise increases the number of shares outstanding, with no effect on
earnings. Additionally, when the options are exercised, shares are sold to executives for less than
the current market price; in effect, current shareholders have Agiven away@ an ownership share
for less than it is currently worth, thereby diluting the wealth of each current shareholder. Of
course, this fact misses the key incentive feature of the option grant in the first place: the
incentives helped the stock price to rise to its current level, above the exercise price.
There are different types of executive stock compensation plans. The one that you are most
familiar with from the financial press is the type of compensation where at the grant date (when
the executive receives the options, usually at the end of the year) the exercise price (the price at
which the executive can buy the shares) is equal to or greater than the company=s stock price.
Such options are called out of the money, and it is not profitable to exercise the options at this
time. Out of the money option compensation is not taxable to the executive at the time of grant,
as if the option were worthless (of course it=s not).
Some important factors pertaining to such options are the vesting period, the time between the
grant date and the first available exercise date, and the option=s expected life, the time between
the grant date and the expected exercise date.
The original method (APB #25) to handle such options is called the intrinsic value method. The
method=s key point is that the firm recognizes no compensation expense at the time of the grant
[if the exercise price is equal to or greater than the company=s stock price]. Again, it=s as if the
option were worthless. Compensation expense at the time the option is granted is recognized
only for the excess of the market price over the exercise price at the grant date. Most options
have the exercise price greater than or equal to the market price at the grant date, thus giving the
executive an incentive to increase the stock price (presumably by good management) because
only if the stock price rises will the options become worthwhile to exercise (called in the money).
SFAS #123 allows companies to calculate compensation expense by the intrinsic value method
or by the fair value method, under which even if the exercise price  the grant date stock price,
the options still have value (because of the potential for the stock price to rise). The fair value
method recognizes compensation expense based on the fair market value of the options granted
(which would be calculated based on an option pricing model). Companies can use either
method, but if they use the intrinsic value method, they must show footnote disclosure of
pro-forma net income and EPS under the fair value method (and the option pricing method
used along with the method=s relevant assumptions).
Under the fair value method, compensation expense equals the fair value of each option x the
number of options that is expected to vest (i.e., the executive is expected to stay for the entire
vesting period). This expense is then recognized on a straight line basis over the vesting period.
The entry is:
DR
CR
compensation expense
paid in capital-stock options
Note that compensation expense is measured only once for a given option, at the grant date.
Subsequent changes in the option=s fair value are ignored. If the options are subsequently
exercised, the entry is:
DR
CR
cash received from exercise
paid in capital-stock options (kill off previous CR)
C/S par
additional paid in capital
If the options are never exercised, there is no further entry, and the CR to paid in capital-stock
options remains.
Since the options have value that matters to the executive and since they are granted in lieu of
other valued consideration (even if the market price  exercise price), the fair value method is the
economically correct way to account for the compensation expense of executive stock options.
Companies do not like it however, because it causes an expense (perhaps a large amount) to be
recognized, whereas the intrinsic value method often shows no expense. This is especially
important for small (high tech) startup companies that report low or negative income, but whose
options might be very valuable due to expected future stock price appreciation. RCJ=s discussion
on pages 774-782 summarizes some of the important issues surrounding the debate over this
contentious financial reporting issue.
Most companies still use the intrinsic value method, thereby avoiding putting the compensation
expense of the options on the I/S. As RCJ discuss, the pro-forma disclosures required under this
method often fail to reflect the full impact of the options on NI.