Accounting for Stock Options

Employee stock options differ substantially from traded options. Most expire within 90 days of the termination of employment, and are forfeited if the employee leaves before vesting. The major accounting standards boards are in agreement that options should be expensed, but companies have legitimate complaints about the proposed methods. For example, the proposals create accounting incentives for firms to lay off employees who hold unvested and nearly worthless options. We propose a simple accounting system, based on 90 day option prices, that addresses these legitimate objections. The system produces objective, transparent, and decision-relevant information. Firms are given significant flexibility regarding the amortization of unvested option expense. This flexibility is created, without distorting incentives, by our use of market-based prices whenever an option expense is recognized.