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Reprint: R0312J

Now that companies such as General Electric and Citigroup have accepted the premise that employee stock options are an expense, the debate is shifting from whether to report options on income statements to how to report them. The authors present a new accounting mechanism that maintains the rationale underlying stock option expensing while addressing critics concerns about measurement error and the lack of reconciliation to actual experience.

A procedure they call fair-value expensing adjusts and eventually reconciles cost estimates made at grant date with subsequent changes in the value of the options, and it does so in a way that eliminates forecasting and measurement errors over time. The method captures the chief characteristic of stock option compensationthat employees receive part of their compensation in the form of a contingent claim on the value they are helping to produce.

The mechanism involves creating entries on both the asset and equity sides of the balance sheet. On the asset side, companies create a prepaid-compensation account equal to the estimated cost of the options granted; on the owners-equity side, they create a paid-in capital stock-option account for the same amount. The prepaid-compensation account is then expensed through the income statement, and the stock option account is adjusted on the balance sheet to reflect changes in the estimated fair value of the granted options. The amortization of prepaid compensation is added to the change in the option grants value to provide the total reported expense of the options grant for the year. At the end of the vesting period, the company uses the fair value of the vested option to make a final adjustment on the income statement to reconcile any difference between that fair value and the total of the amounts already reported.

Now that companies such as General Electric, Microsoft, and Citigroup have accepted the premise that employee stock options are an expense, the debate on accounting for them is shifting from whether to report options on income statements to how to report them. The opponents of expensing, however, continue to fight a rearguard action, arguing that grant-date estimates of the cost of employee stock options, based on theoretical formulas, introduce too much measurement error. They want the reported cost deferred until it can be precisely determined—namely when the stock options are exercised or forfeited or when they expire.

But deferring recognition of stock option expense flies in the face of both accounting principles and economic reality. Expenses should be matched with the revenues associated with them. The cost of an option grant should be expensed over the time, typically the vesting period, when the motivated and retained employee is presumed to be earning the grant by generating additional revenues for the company. Some degree of measurement error is no reason to defer recognition; accounting statements are filled with estimates about future events—about warranty expenses, loan loss reserves, future pension and postemployment benefits, and contingent liabilities for environmental damage and product defects. What’s more, the models available for calculating option value have become so sophisticated that valuations for employee stock options are probably more accurate than many other estimates in a company’s financial statements.

The final defense of the antiexpensing lobby is its claim that other financial-statement estimates based on future events are eventually reconciled to the settlement value of the items in question. For instance, estimated costs for pension and postretirement benefits and for environmental and product-safety liabilities are ultimately paid in cash. At that time, the income statement is adjusted to recognize any difference between actual and estimated cost. As the opponents of expensing point out, no such correcting mechanism currently exists to adjust grant-date estimates of stock option costs. This is one of the reasons why high-tech company CEOs such as Craig Barrett of Intel still object to the proposed Financial Accounting Standards Board (FASB) standard for grant-date accounting for stock options.

A procedure that we call fair-value expensing for stock options eliminates forecasting and measurement errors over time.

It is, however, easy to provide an accounting mechanism that maintains the economic rationale underlying stock option expensing while addressing critics’ concerns about measurement error and the lack of reconciliation to actual experience. A procedure that we call fair-value expensing adjusts and eventually reconciles cost estimates made at grant date to subsequent actual experience in a way that eliminates forecasting and measurement errors over time.

The Theory

Our proposed method involves creating entries on both the asset and equity sides of the balance sheet for each option grant. On the asset side, companies create a prepaid-compensation account equal to the estimated cost of the options granted; on the owners’-equity side, they create a paid-in capital stock-option account for the same amount. This accounting mirrors what companies would do if they were to issue conventional options and sell them into the market (in that case, the corresponding asset would be the cash proceeds instead of prepaid compensation). The estimate for the asset and owners’-equity accounts can come either from an options pricing formula or from quotes provided by independent investment banks.

The prepaid-compensation account is then expensed through the income statement following a regular straight-line amortization schedule over the vesting period—the time during which the employees are earning their equity-based compensation and, presumably, producing benefits for the corporation. At the same time that the prepaid-compensation account is expensed, the stock option account is adjusted on the balance sheet to reflect changes in the estimated fair value of the granted options. The company obtains the periodic revaluation of its options grant just as it did the grant-date estimate, either from a stock options valuation model or an investment-bank quote. The amortization of prepaid compensation is added to the change in the value of the option grant to provide the total reported expense of the options grant for the year.

At the end of the vesting period, the company uses the fair value of the vested stock option—which now equals the realized compensation cost of the grant—to make a final adjustment on the income statement to reconcile any difference between that fair value and the total of the amounts already reported in the manner described. The options can now be quite accurately valued, as there are no longer any restrictions on them. Market quotes would be based on widely accepted valuation models.

Alternatively, if the now-vested stock options are in the money and the holder chooses to exercise them immediately, the company can base the realized compensation cost on the difference between the market price of its stock and the exercise price of its employee’s options. In this case, the cost to the company will be less than if the employee had retained the options because the employee has forgone the valuable opportunity to see the evolution of stock prices before putting money at risk. In other words, the employee has chosen to receive a less valuable compensation package, which logically should be reflected in the company’s accounts.

Some advocates of expensing might argue that companies should continue to adjust the grant’s value after vesting until the options are either forfeited or exercised or they expire unexercised. We feel, however, that the company’s income-statement accounting for the grant should cease at the time of vesting or almost immediately thereafter. As our colleague Bob Merton has pointed out to us, at the time of vesting, the employee’s obligations regarding earning the options cease, and he or she becomes just another equity holder. Any further transactions on exercising or forfeiture, therefore, should lead to adjustments of the owners’-equity accounts and the company’s cash position, but not the income statement.

The approach we have described is not the only way to implement fair-value expensing. Companies may choose to adjust the prepaid-compensation account to fair value instead of the paid-in capital option account. In this case, the quarterly or annual changes in option value would be amortized over the remaining life of the options. This would reduce the periodic fluctuations in option expense but involve a slightly more complex set of calculations. Another variant, for employees doing research and development work and in start-up companies, would be to defer the start of amortization until the employees’ efforts produce a revenue-generating asset, such as a new product or a software program.

The great advantage of fair-value expensing is that it captures the chief characteristic of stock option compensation—namely that employees are receiving part of their compensation in the form of a contingent claim on the value they are helping to produce. During the years that employees are earning their option grants—the vesting period—the company’s expense for their compensation reflects the value they are creating. When employees’ efforts in a particular year yield significant results in terms of the company’s share price, net compensation expense increases to reflect the higher value of those employees’ option-based compensation. When employees’ efforts do not deliver a higher share price, the company faces a correspondingly lower compensation bill.

The Practice

Let’s put some numbers into our method. Assume that Kalepu Incorporated, a hypothetical company in Cambridge, Massachusetts, grants one of its employees ten-year stock options on 100 shares at the current market price of $30, vesting in four years. Using estimates from an option pricing model or from investment bankers, the company estimates the cost of these options to be $1,000 ($10 per option). The exhibit “Fair-Value Expensing, Scenario One” shows how the company would expense these options if they end up being out of the money on the day they vest.

In year one, the option price in our scenario remains constant, so only the $250 amortization of prepaid compensation is recognized as an expense. In year two, the option’s estimated fair value decreases by $1 per option ($100 for the package). Compensation expense remains at $250, but a $100 reduction is made to the paid-in capital account to reflect the decline in the options’ value, and the $100 is subtracted in the calculation of year two’s compensation expense. In the following year, the option revalues by $4, bringing the grant value up to $1,300. In year three, therefore, the total compensation expense is the $250 amortization of the original grant, plus an additional option expense of $400 due to the revaluation of the grant to a much higher value.

Fair-value expensing captures the chief characteristic of stock option compensation—that employees receive part of their pay in the form of a contingent claim on value they are helping to produce.

By the end of year four, however, Kalepu’s stock price plummets, and the fair value of the options correspondingly falls from $1,300 to just $100, a number that can be precisely estimated because the options can now be valued as conventional options. In the final year’s accounting, therefore, the $250 compensation expense is reported along with an adjustment to paid-in capital of minus $1,200, creating a total reported compensation for that year of minus $950.

With these numbers, the total paid compensation over the whole period comes out to $100. The prepaid-compensation account is now closed out, and there remains only $100 of paid-in capital in the equity accounts. This $100 represents the cost of the services rendered to the company by its employees—an amount equivalent to the cash the company would have received had it simply decided to write the options, hold them for four years, and then sell them on the market. The $100 valuation on the options reflects the current fair value of options that are now unrestricted. If the market is actually trading options with exactly the same exercise price and maturity as the vested stock options, Kalepu can use the quoted price for those options instead of the model on which that quoted price would be based.

What happens if an employee holding the grant decides to leave the company before vesting, thereby forfeiting the unvested options? Under our approach, the company adjusts the income statement and balance sheet to reduce the employee’s prepaid-compensation asset account and the corresponding paid-in capital option account to zero. Let’s assume, for example, that the employee leaves at the end of year two, when the option value is carried on the books at $900. At that time, the company reduces the employee’s paid-in capital option account to zero, writes off the $500 remaining on the prepaid-compensation balance sheet (after the year-two amortization had been recorded), and recognizes a gain on the income statement of $400 to reverse the two prior years of compensation expenses. In this way, Kalepu “trues up” the total reported equity-based compensation expense to the realized value of zero.

If the option price, instead of declining to $1 at the end of year four, remains at $13 in the final year, the company’s year-four compensation cost equals the $250 amortization, and the total compensation cost over the four years is $1,300, which is higher than had been expected at the time of the grant. When options vest in the money, however, some employees may choose to exercise immediately rather than retain the full value by waiting to exercise until the options are about to expire. In this case, the firm can use the market price of its shares at the vesting and exercise dates to close off the reporting for the grant.

To illustrate this, let’s assume that Kalepu’s share price is $39 at the end of year four, when the employee’s options vest. The employee decides to exercise at that time, forgoing $4 worth of benefits per option and thereby lowering the cost of the option to the company. The early exercise leads to a minus $400 year-four adjustment to the paid-in capital option account (as shown in the exhibit “Fair-Value Expensing, Scenario Two”). The total compensation expense over the four years is $900—what the firm actually gave up by providing 100 shares of stock to the employee at a price of $30 when its market price was $39.

Following the Spirit

The objective of financial accounting is not to reduce measurement error to zero. If it were, a company’s financial statements would consist merely of its direct cash-flow statement, recording cash received and cash disbursed in each period. But cash-flow statements do not capture a company’s true economics, which is why we have income statements, which attempt to measure the economic income of a period by matching the revenues earned with the expenses incurred to create those revenues. Accounting practices such as depreciation, revenue recognition, pension costing, and allowance for bad debts and loan losses permit a better, albeit less precise, measurement of a company’s income in a period than would a pure cash-in, cash-out approach. In a similar way, if the FASB and International Accounting Standards Board were to recommend fair-value expensing for employee stock options, companies could make their best estimates about total compensation cost over the vesting life of the options, followed by periodic adjustments that would bring reported compensation expense closer to the actual economic cost incurred by the company.

Krishna G. Palepu (kpalepu@hbs.edu ) is the Ross Graham Walker Professor of Business Administration at Harvard Business School. They are coauthors of three previous HBR articles, including Strategies That Fit Emerging Markets (June 2005).