Unformatted text preview: her market price and
the exercise price. It creates a cost to the company even if the company is not
going to the market to buy its shares. The company is giving up the opportunity
to sell these shares in the market at a higher price. Hence, the opportunity cost
is the difference between the exercise price and the higher market price (Newell
& Kreuze, 1997).
3.4.2 Arguments For No Expense Recognition
Despite all the many reasons for recognizing the stock-based compensation as
an expense there are a lot of defendants of the contrary treatment. The main
arguments presented by those disagreeing with the idea of expensing stockbased compensation plans are described below (Borrus, et al., 2002):
• Unlike salaries or other means of compensation, granting stock options
results in no cash outlay for companies. Since there is no cost for a
company to deduct, expensing stock-based compensation plans will only
result into negative and unjustified reductions of earnings.
• There are no specific methods developed to measure stock-based
compensation expense. All valuation methods require many assumptions
and estimates. This situation can lead to reduced accuracy in financial
statements and opens the way for manipulation.
• Deduction of stock-based compensation expense will reduce earnings,
which might result in a fall in share prices.
• In order to secure earnings companies might start issuing fewer options.
This will limit companies’ ability to keep talented employees and
restrain companies’ ability to align the employees’ and shareholders’
Finally, according to Sahlman (2002), expensing stock-based compensation
plans will not add any more information that is not already included in the
financial statements. On the contrary, it might lead to less information in the
footnotes to financial statements and to a more distorted picture of a company’s
economic condition. 3.5 Methods to Measure Stock-Based Compensation Expense 27 In this section we discuss various methods of measuring the expense that may
result from stock-based compensation plans. Some of the proposed methods are
based on option pricing models. We begin this section with a short explanation
of some terms used in relation to options, their pricing and application to stockbased compensation plans. Following these explanations, we present an
overview of models used to price stock options, including some comments on
the difficulties to be encountered when using such models.
3.5.1 Explanation of Option-Specific Terms
The fixed price of the option, which was agreed by both, the writer of the
option and its holder, and at which the holder can buy or sell an underlying
asset, is referred to as the striking price or exercise price (Ross, et al., 1996).
There are two main types of options with regard to expiration: a European
option and an American option. European options cannot be exercised before
the expiration date, while American options can be exercised at any date after
they are vested (www.e-analytics.com/optbasic).
Factors, which might influence the price of an option are as follows (www.eanalytics.com/optbasic):
• The price of the underlying asset
The striking price of the option itself
The time remaining till the expiration date
The volatility of the underlying stock (in case of stock options)
Expected dividends on the underlying stock
The risk-free interest rate for the expected life of the option. Stock volatility is one of the most influential factors. The concept of volatility
describes the stock’s tendency to undergo price changes. There are several
types o f v olatility d efined: h istorical, f orecast a nd i mplied v olatility
(www.mdwoptions.com/volatility). Historical volatility is calculated measuring
the actual movements in prices the stock has undergone in the past. However, it
is more important to know the volatility the stock is going to have from the date
of option issue till the date of expiration. In this case, volatility can hardly be
precisely calculated, as the time frame is the future. Thus the volatility should
be estimated. The estimated future volatility is called forecast volatility.
Implied volatility, on the other hand, applies to the option itself rather than to
the underlying stock (www.ivolatility.com/news).
As discussed previously, stock-based compensation plans can be measured at
either intrinsic or fair value. (See Section 1.2) Under the intrinsic value based
28 method, compensation cost is recognised as an intrinsic value at the grant date.
The intrinsic value is the difference between the current market price of the
underlying stock and the exercise price of the option. Under this method most
stock option grants result in no expense as the exercise price of the option on
the grant date is normally equal to the fair value of the underlying stock
(Pippolo, 2002). When an expense is calculated, using the intrinsic value
method (i.e., when market price is not equal to exercise price at grant date), the
compensation cost is recognised...
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This document was uploaded on 10/31/2013.
- Fall '13