Because an employee with stock options can purchase

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es. Because an employee with stock options can purchase stock at a fixed price and resell e prevailing (expectedly higher) market price, the options create the possibility of a future Unlike cash compensation, options give employees the same incentives as shareholders-to e stock price. -er the past 30 years, use of stock options has skyrocketed and options now make up the of many executive compensation packages. Despite their popularity, stock options have a ide-they can create incentives for employees to increase stock price at any cost and by eans, including misstating earnings and engaging in transactions whose sole purpose is to stock' price. Options can also induce managerial myopia- managers want stock price to e, at least until they can exercise their options and capture their gains. Lntil recently, companies were not required to record the value of stock options as compen- expense. Previous GAAP (APB 25) held that options had value only to the extent that the ermined purchase price (exercise price) was less than the market stock price on the date that tions were granted to the employee. If a company sets the exercise price equal to the market -- on the date of grant, the view was that nothing of value had been given to the employee. This r that no compensation expense was ever reported on such options. This reduced the quality reported earnings because companies sheltered their income statements merely by setting the ise price equal to the market price of the stock on the date of grant. Analysts and investors long expressed serious concerns about accounting for stock options and the amount of unre- compensation expense tied to options. Under considerable pressure and controversy, the FASB issued a pronouncement (SFAS ~ ) that applies to stock options granted after 2005. Under the pronouncement, companies expense the fair value of options and recognize an equivalent increase in stockholders' -.; (to the additional paid-in capital account). To illustrate the accounting for stock options, assume that Aon grants an employee 100,000 - . options with a strike price of $26, which will vest over a four-year period. The vesting - is the time over which an employee gains ownership of the shares, commonly over to seven years. Employees usually acquire ownership ratably over time, such as 114each over four years, or acquire full (100%) vesting after the vesting period ends, called cliff ·ng. Under SFAS 123R, Aon recognizes the fair value of the stock options granted over the loyees' service period (generally interpreted as the options' vesting period). A.first step, then, is to determine the "fair value" of the option. SFAS 123R does not ify the method companies must use to estimate fair value, but most companies use the k-Scholes model to estimate the value of exchange-traded options. This model, developed _ professors Fischer Black and Myron Scholes, has six inputs, two of which are observable company's current stock price and the option's strike price). Companies must estimate the r four model inputs: option life, risk-free interest rate, stock price volatility, and dividend yout rate. These six inputs yield an estimate of the option's fair value. It is important we
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