Most of the debate is over whether options should be counted as an expense, which would reduce reported earnings and possibly undermine share prices. What effect do options have on the number of stock shares a company has in circulation?
The answer can make a big difference when a company computes its earnings per share, and when investors calculate the critical price-to-earnings ratio. Core , professor of accounting at Wharton, and S. The paper was published in The Accounting Review in July , and has special relevance now because regulators such as the Financial Accounting Standards Board are expected to modify options accounting rules next year.
Understating dilution inflates earnings per share, the authors say. Employee options give their owners the right to buy shares at a set price anytime over a given period. The right to exercise the options may vest all at once or in stages on the first few anniversaries of the grant. Employee options usually expire if they are not exercised within 10 years. Options appeal to employees because they can convey great value without requiring that the employee put money at risk, as one does owning actual shares of stock.
By , that figure had grown to 8. The growing use of options has raised a debate about how they should be accounted for. Some advocate carrying them as an expense, arguing options have value and should be considered a compensation cost just like wages and other benefits. This issue has received a great deal of attention in the past few years, and the FASB expected to issue new rules in requiring some form of expensing.
But this still leaves the second problem of how to account for options-related dilution of share value, Guay and his colleagues say. Companies have various ways of providing the shares needed to turn over to employees who exercise options.
Some companies draw on a reserve of shares that have not yet been in circulation. Others use profits to buy back shares on the open market, using them to build a reserve to meet options exercises. If a company had one million shares outstanding and employees exercised options to purchase , shares, there would then be 1. In practice, the accounting is not as simple as in this example. Many options holders wait to exercise until shortly before their options expire, hoping the share price will rise further.
Under current accounting rules, this uncertainty is handled in a fairly simple way: Those are options with a strike price lower than the current market price. A company might have one million options outstanding, but count only , in the diluted earnings per share calculation.
The problem with this approach, the authors say, is that it uses too low a figure for potential options-related profits. That means it understates the number of shares that could be bought with those profits. Hence, the dilution is understated as well.
In fact, this is what the typical employee does. In addition, the FASB method assigns no value to options that could not be exercised at a profit. Those are at-the-money options, where the strike price and market price are the same, and out-of-the-money options, where the strike price is higher than the market price. To figure just how much value the in-, at-, and out-of-the-money options have to their owners, the authors studied options plans from to That means the options-related profits could buy more shares, causing greater dilution when those are added to common shares to figure diluted earnings per share.
Among all the options plans studied, the authors found that options should increase the number of shares used in the diluted earnings-per-share calculation by 2. The FASB method accounted for only half the dilution — 1. Guay says he and his colleagues are not wedded to their own options-valuation model, since any approach involves a lot of assumptions about factors like future stock prices and at what point employees will choose to exercise.
But they believe their findings demonstrate that rule makers should go beyond the current debate about whether to count options as an expense. They also should seek a better way of figuring how options undermine the value of ordinary shares.
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