The IASB and FASB are considering expensing for employee options. They agree that employee options cannot be traded, hedged (jail for shorting your own stock), or even exercised until vesting. Thus they need a discount from any delta hedging model. Current IASB and FASB proposal is for accountants to estimate when employees are expected to exercise, and use this expected life as the term in Black Scholes. This gets a low value if expected life is short. Unfortunately this encourages shorter vesting. Shorter vesting enables pump and dump behavior that is so costly to shareholders. Meanwhile long vesting which is better for shareholders but worse for employees gets long expected life and a high expense. This expected life discount is backwards, and by motivating short vesting, can actually motivate more Enrons. I hope all that understand option pricing and employee options should help IASB and FASB to get this right. A fair and proper expense for employee options can continue can enable their continued use to align employees and executives to build shareholder value. In my experience, proper use of options for employee bonuses is a win-win tactic, sharing wealth with employees in good times, and causing no shareholder harm in bad times.I've written a letter to FASB and IASB which I will post soon.EOAvocate

IMHO the valuation should be conservative, thus should take the date which maximizes the cost.

a simple solution: for a listed company buy the options from a banka more complicated one: force the company to give a valuation every year of all outstanding options using any methodology chooses for each year of maturityand force the inclusion of its valuation of these options the previous year . i.e. a statement of how much it got it wrong the previous yearand any option that is exercised in that year must be valued at its instrinsic value at time of exercise. best solution: abolish employee options as they don't achieve much beyond exposure to the index and instead give employees a fraction of dividend payments for the next ten years. MJ

Recently FASB adopted a new expense requirement for vesting stock options. As the vesting restriction comes off shares of the bonus, the number of shares priced at the grant date stock price is the expense. Notice that this later expense with the grant date stock price captures the grant date cost of the restricted stock bonus, but it removes the capital gain during the vesting from the expense. This makes sure that the dilution cost of the shares is captured as a compensation expense, but the capital gains earned by the employee are irrelevent to corporate accounting. I think that this is correct.The same procedure could be used for employee options, expensing the equivalent bonus shares of the option with the grant date share price. When an option is exercised, the shares are obtained by paying the exercise price, which is less than the full price. Think of this as buying some shares at full price, and getting the rest of the shares for free. These free shares are like a contingent, vesting stock bonus. Then expense the free shares by the grant date share price to be consistant with vesting stock bonuses, and keep the capital gain out of the compensation expense. The intrinsic value, which includes capital gains, is max(0, ST-X) where ST is the current shareprice and X is the exercise price. This clearly includes the capital gain of the rising stock price. To keep capital gains out of the expense, use S0*max(0,1-X/ST) where S0 is the grant date shareprice. Multiplying free shares times grant date price eliminates the capital gain.This exercise date procedure keeps the expensing of employee options on a par with the expensing of vesting stock bonuses. It looks right to me. But IASB and FASB would prefer a grant date expense. What probability distribution should I use to calculate my expected free shares at the grant date?EOAdvocate

It seems to me that the moment that the tax & accounting treatment is changed there will be a budget for hring someone from this forum to find a way of exploiting it Remembering ppauper's wise words, I have a constructive suggestion.The government may choose to swap part of the tax liability of the firm for options at the value the firm claims them to have. If a firm prices the options fairly, then this is neutral. If they are excessively generous then there is an automatic penalty when exercised. Firms may then choose any method for pricing options they like.This will show very quickly in the accounts.

DCFC, your idea of being able to pay corporate taxes with stock options priced at whatever the company thinks their value is is truely a unique idea. Lets follow it a llittle. As a major shareholder in a firm, I like the idea of paying taxes with stock options. The government's job is to regulate my firm, looking for violations securities law, tax avoidance, environmental rules, or labor laws. Perhaps if the government held our stock options, they would align more with our goals. If the government would just look away, we could make a lot of money, and the government's stock options would be worth a lot more. Employee stock options are supposed to align shareholder and employee goals. This should also work well to align goverrment regulators with the desires of shareholders.On second thought, as a citizen and a taxpayer, I don't think the government should own stock options on the firms it regulates. But it's a unique idea DCFC, keep them coming.ppauper, and MJ, re buying employee options from a bank. In the mid 90's I was aware of a major investment banker trying to hedge company's employee stock options. There was a lot of interest until the firms heard the price. Of course the bank had to charge something like Black Scholes to delta hedge the risk. This seemed too high a price to the firms. Why? Because they are already automatically hedged at no cost their own treasury stock. To my knowledge the investment banker did almost no business. Anyone know differently? Thus I think the cost to a firm of employee options is less than delta hedging models like Black Scholes, and much less if the underlying volatiltiy is high.EOAdvocate

Those who issue employee options would sure like the expense to be zero. If I am honest I have to admit that expensing should be much like stock bonuses, especially with vesting stock bonuses. Without vesting, an employee stock bonus comes from treasurey stock, is an immediate increase in shares outstanding, and is an immediate expense of the shares times the stock price. You could call this a double hit to earnings per share, but it is the current stock bonus accounting rule. For a vesting stock bonus, as the vesting comes off the bonus shares, the shares add to outstanding shares and there is an expense of the grant date share price times the new shares. Again a double hit, but this time the expense is with the grant date price, so that the employee's capital gains is excluded from the compensation expense.My recommendation is that this same procedure could work with employee options, expensing the "free shares" from the option times the grant date stock price.EOAdvocate

Here's my letter to FASB and IASB that lays my solutions to employee option expense. There's the exercise date free shares time grant date price; the grant date which calculating expected free shares at the grant date price; minimum value just because it looks like my other values; and minimum value at vesting to be most like vesting stock bonuses. Hope you enjoy my Dilbert joke. EOAdvocate

I'm so good at files? I think I've attached a zip file, but if not any suggestions about what I'm doing wrong? EOAdvocate

No zip file.While my position is likely a matter of having only a hammer, and so thinking that every problem is a nail, I think that employee options would best be expensed in a manner similar to pension plans (did I mention that I'm a pension actuary?).With pension plans, a valuation is made (actually, several valuations are made to serve different purposes, mostly related to differing taxation, contribution, and accounting requirements) based upon assumptions that are at turns market-dependent and particular to the sponsoring company, and these assumptions have to be fairly clearly stated, albeit maybe less clearly than I'd like. Many of the accounting assumptions are pretty much set in stone due to FASB instructions and requirements. In particular, the discount rate for pension liabilities is to be based upon high quality corporate bonds with maturities similar to the pension liabilities, and when you look at the discount rate used by different companies, it is very consistent -- very close to 6.75% for 2002.Other assumptions, particularly the expected rate of return on assets, are much more subjective, and sometimes the assumptions made are just plain stooopid -- expected annual rates of return of 9.5% last year are not uncommon. But they are at least reported, and so it is pretty straight-forward to eliminate the effect of stupidity in assumptions. (There is also debate about what basis should be used for the return on assets, but that's another matter.)Similarly, I think that employee options should just be valued with a clear statement of assumptions used. I'd prefer that non-vested options be proportionally expensed, based upon how many are expected eventually to become vested based upon assumptions about rates of termination of employment and that the optimal exercise date from the perspective of employees (who after all are the ones deciding when to exercise) be assumed, but I can appreciate arguments for other treatments.In any case, the assumptions should be clearly stated. Probably the most contentious assumption would be the volatility. I'd ideally want to see an assumed volatility that is less than the implied volatility of traded options or historical volatility, to reflect that the options are freely hedged with treasury stock, but others might disagree, and in any case there is no good answer that I know of to the question of how much less the volatility assumption for expensing employee options should be, and what are good reasons for varying it more or less for a given company. But if the assumption used is clearly stated, anyone who thinks a different assumption would be better will have at least an idea of how much and in which direction the expense quoted should be adjusted to meet his ideal valuation assumptions.

By the way, more than a few recent proxy ballots of companies I own stock in had shareholder proposals to begin expensing options. The proposals themselves were unremarkable, but the management recommendations (in all cases "AGAINST") were informative. The typical management recommendation went something like this (I may have taken some mild liberties in paraphrasing):QuoteYeah, well maybe you're right. But our competitors are lying in pretty much the same way that we're lying, and we figger it makes more sense to lie in a way consistent with our competitors than to tell the truth.My confidence in these management teams was not inspired.