Accounting for stock options - am I missing something?

• Author: Roy, P. Norman
• Position: From the President - Column

Large sums associated with the exercise of stock options have raised questions of excessive executive compensation and focused attention on an issue that was dormant for years. Many arguments have been advanced -- both pro and con -- regarding the decision of the Financial Accounting Standards Board to issue a proposal requiring companies to recognize an expense for all stock compensation awards, including stock options.

For stock options the expense would be measured as the fair value at the date the option is granted. "Fair value" would be derived from projections of future market value of the stock using Black-Scholes or some other mathematical model. After a three-year disclosure period, companies would be required to deduct the expense from earnings. FASB Chairman Dennis R. Beresford has stated that the "present practice in accounting for stock options produces inconsistent results ... which impairs the credibility of financial statements. We believe that our current proposal would improve this area of financial reporting."

There has been a lot of debate about the value of options. Certainly they have a value. Why else would they be welcomed by corporate executives? But how does one determine the value of an option? Its value at the time of grant can only be measured by the prospects for future appreciation in the market value of the underlying stock. While a number of sophisticated valuation models have been developed, like the Black-Scholes model, none have proven to be reliable indicators of future value.

Although many options have proven to have extraordinary value, others, perhaps in equal numbers, have proven to have no value at all. Options for the purchase of stock whose price remains under water have no value and ultimately will expire without being exercised. And whether or not the options ultimately have value over their exercise period, is it appropriate to charge against earnings any expense based on future stock market value projections...