Employee stock option

An employee stock option (ESO) is commonly viewed as a complex call option on the common stock of a company, granted by the company to an employee as part of the employee's remuneration package. Regulators and economists have since specified that ""employee stock options"" is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options but are not in and of themselves options (that is they are ""compensation contracts"").As described in the AICPA's Financial Reporting Alert on this topic, for the employer who uses ESO contracts as compensation, the contracts amount to a ""short"" position in the employer's equity, unless the contract is tied to some other attribute of the employer's balance sheet. To the extent the employer's position can be modeled as a type of option, it is most often modeled as a ""short position in a call."" From the employee's point of view, the compensation contract provides a conditional right to buy the equity of the employer and when modeled as an option, the employee's perspective is that of a ""long position in a call option."" Employee Stock Options are non standard contracts with the employer whereby the employer has the liability of delivering a certain number of shares of the employer stock, when and if the employee stock options are exercised by the employee. Traditional employee stock options have structural problems, in that when exercised followed by an immediate sale of stock, the alignment between employee/shareholders is eliminated. Early exercises also have substantial penalties to the exercising employee. Those penalties are a) part of the ""fair value"" of the options, called ""time value"" is forfeited back to the company and b) an early tax liability occurs. These two penalties overcome the merits of ""diversifying"" in most cases.Stock option expensing was a controversy well before the most recent set of controversies in the early 2000s. The earliest attempts by accounting regulators to expense stock options in the early 1990s were unsuccessful and resulted in the promulgation of FAS123 by the Financial Accounting Standards Board which required disclosure of stock option positions but no income statement expensing, per se. The controversy continued and in 2005, at the insistence of the SEC, the FASB modified the FAS123 rule to provide a rule that the options should be expensed as of the grant date. One misunderstanding is that the expense is at the fair value of the options. This is not true. The expense is indeed based on the fair value of the options but that fair value measure does not follow the fair value rules for other items which are governed by a separate set of rules under ASC Topic 820. In addition the fair value measure must be modified for forfeiture estimates and may be modified for other factors such as liquidity before expensing can occur. Finally the expense of the resulting number is rarely made on the grant date but in some cases must be deferred and in other cases may be deferred over time as set forth in the revised accounting rules for these contracts known as FAS123(revised).