Expensing Stock Options: The Controversy - 29 Aug 2009 - Harvard Business

Some believe that expensing stock options helps to more truly
represent a company's financial standing; thus it's appropriate. Others
believe that expensing options hinders the ability of small growth
companies to succeed.

Recently Joe attended a national conference where a keynote speaker,
a former CEO of one of the most successful retail chains, said that had
he been forced to expense options during the growing years of the
business, the company would never have succeeded. First, because they
would have used fewer options to recruit, thus limiting the talent they
could attract. Second, they would have taken much longer to get to
profitability because of the added expense of options. The law changed
in 2006, and people are still debating it. So go accounting
controversies! Here is a primer on the subject.

Stock options are often used as a way to entice employees to join a
small start-up company at lower than market salaries. Often, these
employees are betting that the stock options will be worth millions
when the company's shares grow above the option's strike price, or its
price when the option was issued.

The strike price of an option is usually issued to new employees at
or above the fair market value of the stock on the date of issue. For
example, the strike price may be $3.00 a share, but at the time of
issue the company's stock is trading at $2.50 a share. That is when the
option is considered underwater there is no taxable gain to the employee who is issued this option.

Until 2006, these options were simply reported in the notes section of the financial statements in accordance with the Generally Accepted Accounting Principles
(GAAP), but did not impact the financial statements themselves. In 2006
FAS 123 of the GAAP code was modified to require companies to show
options as an expense on the income statement. This means that the
costs of these options would be shown as employee compensation along
with salaries and other expenses. The controversy began.

The argument for expensing options was simple. First, investors like
Warren Buffet argued for years that many companies enticed executives
and managers with lower-than-market salaries because they also offered
options. This inflated the companies' profits because of the lower
salaries — hence lower expenses on the income statement.

In addition, if the company did well and the stock options
appreciated, then the shares outstanding were diluted by these options
that were now "in the money."

The other side of the argument is based on the fact that it is very difficult to value

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