Please forward this error screen to sharedip-10718044127. Financial Reporting Alert on this topic, for wiley gaap 2015 pdf free download 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. Early exercises also have substantial penalties to the exercising employee. These two penalties overcome the merits of “diversifying” in most cases. 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.
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. If the company’s stock market price rises above the call price, the employee could exercise the option, pay the exercise price and would be issued with ordinary shares in the company. The employee would experience a direct financial benefit of the difference between the market and the exercise prices. If the market price falls below the stock exercise price at the time near expiration, the employee is not obligated to exercise the option, in which case the option will lapse. Restrictions on the option, such as vesting and non-transferring, attempt to align the holder’s interest with those of the business shareholders. Another substantial reason that companies issue employee stock options as compensation is to preserve and generate cash flow.
The cash flow comes when the company issues new shares and receives the exercise price and receives a tax deduction equal to the “intrinsic value” of the ESOs when exercised. They may also be offered to non-executive level staff, especially by businesses that are not yet profitable, insofar as they may have few other means of compensation. Alternatively, employee-type stock options can be offered to non-employees: suppliers, consultants, lawyers and promoters for services rendered. Employee stock options are similar to exchange traded call options issued by a company with respect to its own stock. At any time before exercise, employee stock options can be said to have two components: “time value” and “intrinsic value”. Any remaining “time value” component is forfeited back to the company when early exercises are made.
Most top executives hold their ESOs until near expiration, thereby minimizing the penalties of early exercise. Employee stock options are non-standardized calls that are issued as a private contract between the employer and employee. Over the course of employment, a company generally issues ESOs to an employee which can be exercised at a particular price set on the grant day, generally the company’s current stock price. Depending on the vesting schedule and the maturity of the options, the employee may elect to exercise the options at some point, obligating the company to sell the employee its stock at whatever stock price was used as the exercise price. At that point, the employee may either sell the stock, or hold on to it in the hope of further price appreciation or hedge the stock position with listed calls and puts. The employee may also hedge the employee stock options prior to exercise with exchange traded calls and puts and avoid forfeiture of a major part of the options value back to the company thereby reducing risks and delaying taxes. The exercise price is non-standardized and is usually the current price of the company stock at the time of issue.
Alternatively, a formula may be used, such as sampling the lowest closing price over a 30-day window on either side of the grant date. On the other hand, choosing an exercise at grant date equal to the average price for the next sixty days after the grant would eliminate the chance of back dating and spring loading. Often, an employee may have ESOs exercisable at different times and different exercise prices. Standardized stock options typically have 100 shares per contract. ESOs usually have some non-standardized amount. Initially if X number of shares are granted to employee, then all X may not be in his account.
It is possible for some options to time-vest but not performance-vest. This can create an unclear legal situation about the status of vesting and the value of options at all. ESOs often have a maximum maturity that far exceeds the maturity of standardized options. It is not unusual for ESOs to have a maximum maturity of 10 years from date of issue, while standardized options usually have a maximum maturity of about 30 months. With few exceptions, ESOs are generally not transferable and must either be exercised or allowed to expire worthless on expiration day.
This should encourage the holders to reduce risk by selling exchange traded call options. Wealth Managers generally advise early exercise of ESOs and SARs, then sell and diversify. Unlike exchange traded options, ESOs are considered a private contract between the employer and employee. In addition, the employee is subjected to the credit risk of the company. If for any reason the company is unable to deliver the stock against the option contract upon exercise, the employee may have limited recourse. For exchange-trade options, the fulfillment of the option contract is guaranteed by the Options Clearing Corp.
There are a variety of differences in the tax treatment of ESOs having to do with their use as compensation. These vary by country of issue but in general, ESOs are tax-advantaged with respect to standardized options. Employee share schemes that aren’t approved by the UK government don’t have the same tax advantages. Therefore, the design of a lattice model more fully reflects the substantive characteristics of a particular employee share option or similar instrument. Note that employees leaving the company prior to vesting will forfeit unvested options, which results in a decrease in the company’s liability here, and this too must be incorporated into the valuation.