how to create barcode in vb.net 2010 PART ONE The Stock Option Problem in Software

Encode Data Matrix in Software PART ONE The Stock Option Problem

PART ONE The Stock Option Problem
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Accounting $20 10= $10 $10x10,000 Charge Total Expense Quarterly Expense (Income) $100,000
$100,000
$100,000
$300,000
<$200,000>
<$200,000>
Note: The variable expense is amortized over the option vesting period. In this case it is assumed that all of the options are vested.
DETERMINING FAIR VALUE
The reign of APB 25 and zero expense accounting is coming to an end. Under the recommended but not required rules of the existing FAS 123 and, more importantly, under the proposed new rules, the measurement date for options is still the grant date. The valuation method changes, however, from intrinsic value to fair value. Therein lies the big debate: how do you determine the fair value The preferred method of determining fair value has been the Black-Scholes option pricing model, which typically results in a fair value estimate of 30 percent to 50 percent of the face value of the option. For example, the 1000-share option grant with a market exercise price of $25 would have a face value of $25,000, and an estimated fair value using Black-Scholes of $7500 to $12,500. This value would be the total expense for these options, determined at the grant date and amortized over the option vesting period. Thus, if
CHAPTER THREE The Accounting Story
the expense were $12,500 and the options vested at the end of three years, the annual expense for each of those years would be approximately $4167. If, under the new rules, the options have performance features such as vesting based upon performance or an accelerating exercise price they will still have a fixed expense as of the grant date (unlike APB 25, which would have required a variable expense). This allows far more flexibility in designing performance-based options and other incentives without being penalized with adverse accounting. Given all these factors, the FASB/IASB approach seems to make the most sense from an accounting perspective. The fair value treatment recognizes that the options are not free at the time they are granted but have some determinable value. Using the grant date gives companies a set point in time at which to fix the expense. As an aside, it should be noted that for tax purposes the Internal Revenue Service has always used and will continue to use the intrinsic value at exercise date. For example, if an option has an exercise price of $10 and the stock is trading at $100, the individual who exercises that option buys a $100 stock for $10. That results in $90-per-share in taxable income for the individual and a $90per-share expense (or tax deduction) for the company. There has never been any argument against this treatment, perhaps because companies get a valuable tax deduction from it. Under the current and proposed accounting rules, the fair value approach will require some valuation model to be used. I believe that option pricing models like Black-Scholes and more recently developed variants are an effective way to determine the expense, as long as we make appropriate adjustments for terminations, forfeitures, and early exercise. Black-Scholes and its variants are already widely used to communicate to employees and executives as well as to the shareholders and investors the value of their option packages. John Biggs, then chairman and CEO of pension fund TIAA-CREF, noted in his testimony before the Senate Committee on Banking, Housing and Urban Affairs, I can assure [you] that high-tech executives in Silicon Valley use Black-Scholes to communicate total compensation to employees. Those same executives know that having to show the
PART ONE The Stock Option Problem
results of that calculation to shareholders would reduce or even eliminate the earnings of their companies. 13 It should come as no surprise that many corporate managers and executives are now complaining that the Black-Scholes option pricing model overstates the value of their stock options. Yet how can you argue with a pricing methodology that has been used to value millions of option transactions every day for the past 30 years The reluctance to accept Black-Scholes tells us that corporate executives and employees undervalue options; they do not recognize what options are truly worth. The market value of options is significantly more, as Black-Scholes indicates, than most executives and employees are willing to admit. This is understandable since stock options are highly risky derivative securities that few individual investors would have in their portfolios in any significant numbers. Option pricing models estimate the cost of options to the company, which is almost always greater than the value of the options to the executive receiving them. Just as most stocks are worth more as part of a diversified investment portfolio so are the stocks or options that are granted as incentives. When granted in vast numbers, options are part of a highly undiversified portfolio. Because of their high-risk characteristics and the fact that they cannot be sold or traded, options are not fully valued by the employees who receive them. The companies complaining about the valuation methodology are like the lead-foot drivers who try to blame their speedometers when they re ticketed for speeding. In both instances the problem is not with the methodology or measurement; the problem is in the driver s seat. When it comes to executive compensation, options have been doing the driving for far too long. The disparity between the Black-Scholes value and the value perceived by executives and employees delivers a strong message. The perceived lack of worth of options by executives and employees shows that valuable shareholder resources have been misused in the granting of these options. These resources could have been spent more effectively on other incentive vehicles to the benefit of the company, its shareholders, and its employees. Looking at this issue more broadly, the misuse of resources should come as no surprise. Any time that we neglect to accurately
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