The Options Reform Debate Is About to Get Real

Accounting regulators have fired what they say is the last salvo in a decades-long war to require companies to expense their stock option grants, setting the stage for the next battle -- exactly how to do so.

The Financial Accounting Standards Board, or FASB, an independent regulatory body that sets financial accounting rules, has said that by the end of this year, it will pass a new rule forcing companies to count their option grants as a cost, and expense them as such. The goal is twofold: clean up the messy accounting that surrounds such option plans (for instance, companies that argue the options are not a cost still happily take the tax break associated with them), and provide shareholders with a clearer picture of what the actual cost of such plans are and how dilutive they can be.

Companies are currently able to treat stock options as an expense if they so choose. However, few do. Notable exceptions are General Electric ( GE), General Motors ( GM) and Coca-Cola ( KO).

Otherwise, all that's currently required of companies is that they annually provide a pro forma (in other words, hypothetical) accounting of what earnings per share might look like if the company expensed its options. You can find this information in the footnotes of the annual report. "That always gets buried," says David Veeneman, a benefits consultant in Chicago. "Even if you know what you're looking for, it can be tough to find."

At the behest of corporate lobbyists, many in Congress have attempted to stall FASB's plan to require that companies expense their option packages. But most observers say it's only a matter of time before companies will have to deal with a new policy, so rather than debating when or why, the debate should center on how.

Few disagree that options do indeed have a cost to the company. The problems arise when trying to decide how to ascertain that cost.

The Black-Scholes method initially appears to be the simplest. This model for pricing options was developed by Fischer Black and Myron Scholes in 1973 and remains something of a gold standard. The formula incorporates a variety of factors, such as the volatility of a security's return, interest rates, the relationship of the underlying stock's price to the strike price (the price at which the holder can exercise the option and buy the stock), and the time remaining until the option expires.

While the Black-Scholes method has been used for decades, it fails to account for certain aspects of corporate compensation. First, it assumes full ownership, when most option grants vest over a period of years. Second, it assumes a marketable option, whereas employee stock options are generally not transferable or tradable. "The value that Black-Scholes presents is a pretty steep number, though," Veeneman says. "If a company is aggressive with its stock option grants, Black-Scholes will trash its earnings."

Compensation expert and Bloomberg columnist Graef Crystal also scoffs at the notion that employee stock options are too difficult to value simply because they're not wholly owned or tradable. "Employees discount the value of their options more than Wall Street would," he says. "It raises questions as to why companies use a vehicle in which employees don't value it at what it costs."

A modified Black-Scholes approach that grants a greater discount to allow for those discrepancies might be preferable. Like common stock in a privately held company or a thinly traded public one, employee option grants can be subject to a blockage discount. Another discount can be applied to factor in the vesting period.

Another alternative could be to allow companies to wait until the options are exercised, and at that point calculate the expense. As the stock price rises, the cost to the company increases, but only the difference between the current year and the prior year would be expensed. And if the stock price falls, a company could have a negative expense, or credit, that year.

Waiting until exercise to calculate the cost of the option grants counters one of the most basic tenets of accounting, though -- that of matching expenses with revenue. It could also prompt companies to manipulate when options get exercised in an effort to manage their revenue numbers. Every solution, though, could spawn its own problems. The goal, of course, lies in anticipating potential abuses when implementing the new rules.

"You always have to ask: What kinds of games would this rule be likely to inspire?" Veeneman says. "You have to find out where the incentives are in every rule change. When there's an incentive to do something, someone will figure out a way to take advantage of it."

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