A Better Way to Expense Employee Stock Options

A Better Way of Expensing Employee Stock Options

 On July 22, 2009, Senators Carl Levin and John MCCain introduced a bill, the Ending Excessive Corporate Deductions for Stock Options Act, S. 1491. The bill is the product of an investigation conducted by the Permanent Subcommittee on Investigations, chaired by Levin, into the different book and tax reporting requirements for executive stock options.

 Current accounting rules under Financial Accounting Standard 123R require companies to calculate stock options "fair value" on the date of grant. The" fair value" of the options on the date they are granted to executives and employees is then expensed against earnings when the options vest to the grantee.

"Eliminating unwarranted and excess stock option deductions would likely produce as much as $5 to $10 billion annually, and perhaps as much as $15 billion, in additional corporate tax revenues that we can't afford to lose," said Levin.
 At least that is what Senator Levin believes.

 With the above in mind, I propose a better way of expensing employee stock options. It follows:
There is much discussion these days about abuses of equity compensation especially
employee stock options and hybrids like cash settled options, SARs, etc.
Some advocate the idea that the actual expenses charged against income for tax purposes
should not be greater than the expenses charged against earnings. This is what the Levin-
McCain bill is about.

Some also claim that there should be an expense against earnings and taxes in the early
years after the grant whether the ESOs are exercised or not.

Here's a solution:

I first state my objectives:

1. To make the amount that is expensed against earnings equal to the amount
expensed against income for tax purposes over the life of any option (i.e . from
grant day to exercise or forfeiture or expiration).

2. Calculate expenses against earnings and expenses against income for taxes at
grant day and not wait for the exercise of the options. This would make the
liability that the company assumes by granting the ESOs deductible against earning
and taxes at the time the liability is assumed (i.e. on grant day).

3. Have the compensation income accrue to the grantees upon exercise as it is today.

4. Create a standard transparent method of dealing with options grants for earnings
and tax purposes.
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This can be done by calculating the value of the ESOs on the day of grant and expensing
it then against earnings and income tax. But, if the options are later exercised, then the
intrinsic value ( i.e. the difference between the exercise price and the market price of the stock)
on the day of exercise becomes the final expense against earnings and
taxes. Any amounts expensed at grant that were greater than the intrinsic value upon
exercise are to be lowered to the intrinsic value. Any amounts expensed at grant that were
less than the intrinsic value upon exercise will be raised up to the intrinsic value.

Whenever the options are forfeited or the options expire out-of-the-money, the expensed
value at grant will be canceled and there will be no expense against earnings or income
tax for those options.

This can be achieved the following way.

We use the Black Scholes model to calculate the "true value" of the options at grant
days using an expiration date of four years from the grant day, and a volatility equal to
the average volatility over the past 12 months. The assumed interest rate is whatever the
rate is on four year Treasury Bonds and the assumed dividend is what is presently being
paid by the company .

There should be no discretion in the assumptions and the method used to calculate the
"true value". The assumptions are to be standard for all ESOs granted.
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I will illustrate the method by way of an Example:

Assume:

1. That Apple Computer is trading at 165 on August 14, 2009.

2. That an employee is granted ESOs to purchase 1000 shares of the stock with a
maximum expiration date of August 14, 2019 with annual vesting of 250 options
each year for four years.

3. That the exercise price is 165
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In the case of Apple we assume a volatility of .38 for the past 12 months and four years
to expiration day for our "true value" calculation purpose. The interest is 3 percent and
there is no dividend paid.

It is not our objective to be perfect in the initial expensed value because the exact
expensed amount will be the intrinsic values (if any) expensed against earnings and
taxes when the ESOs are exercised.

Our objective is to use a standard transparent expensing method resulting in a standard
accurate expensed amount versus earnings and income for taxes.

For Example:

A) The grant day value for the ESOs to purchase 1000 shares of AAPL would be
$55,000. The $55,000 would be an expense against earnings and income for taxes on the
day of grant.

B) If the employee terminated after slightly more than 2 years, and was not vested on
50% of the options, those were canceled and there would be no expenses for these
forfeited ESOs. The $27,500 expenses against these ESOs would be reversed. If the
stock was $250, when he terminated and he exercised his vested ESOs, the company
would have total expenses for the exercised options of $42,500. Therefore since the
expenses were originally $55,000, the company's expenses were lowered to a total of
$42,500 for earnings and tax purposes.
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Example:
Assume that the stock finished at 120 after 10 years and the employee got nothing for
his vested ESOs. The $55,000 expense would be reversed for earnings and tax purposes
by the company. The reversal will take place on the day of expiration or when forfeited.

Example:
If the stock was 300 in nine years and the employee exercised all his options, the
intrinsic value would be $135,000 and the entire expense against earnings and taxes
would be $135,000. Since $55,000 was already expensed, there would be an additional
$80,000 expensed for earnings and taxes on the day of exercise.

Summary:
I have created a plan for the expenses against taxable income to the company
to equal the expenses against earnings which equals the income to the employee,
when all is said and done.

 Company tax deduction = Company expense against earnings= employee compensation Income.

The expense against taxable income and earnings taken at grant day is just a temporary
expense, which is changed to the intrinsic value when the exercise is made or recaptured
when the ESOs are forfeited or expire unexercised. So the company does not have to
wait for tax charges or expenses against earnings.

John Olagues.