342 arguments for no expense recognition despite all

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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’ interests. 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.

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