Options grant the holder the right to purchase stock at a set price (exercise price) over some fixed time period, usually the closing price at the issue date. They are a one-directional participation in the success of the company - the employee benefits (will exercise the options) only if the stock price goes up. If the price goes down, there is no loss to the employee. Presumably, options therefore give employees the incentives to behave as owners of the company.

Accounting for stock options has been one of the most controversial topics in accounting during the last decade. The principal debate is whether compensation expense should be recognized for stock options and, if so, the periods over which it should be allocated, and the value of options granted.

Companies must choose between two very different methods of accounting for options-based compensation.

APB 25

Before 1995, the provisions of Accounting Principles Board (APB) Opinion 25, issued in 1972, determined accounting for stock options. APB Opinion 25 measured stock options using the intrinsic value method, whereby compensation expense was determined as the excess of the stock price at the measurement date (generally, the grant date) over the option exercise price. Because most stock options had exercise prices at least equal to current market prices, no compensation expense was recognized. This approach ignored any likelihood that the stock price would exceed the exercise price in the future.

FAS 123

In June 1993, FASB attempted to recognize the reality of stock-option value by issuing proposed FAS 123, which required measuring the option value based upon the many factors that reflect its underlying value. Therefore, total compensation expense was to be based upon the fair value of the options expected to vest on the grant date. No adjustments would be made after the grant date in response to subsequent changes in the stock price. Fair value was to be estimated using Black-Scholes or binomial option-pricing models.

In 1995, FASB decided to encourage, rather than require, recognition of compensation cost based upon the fair value method and to require expanded disclosures. In other words, FAS 123 requires companies that continued to follow APB 25 and did not include stock-option expenses in the income statement to disclose in the notes to financial statements what such expenses would have been.

The FASB issued FAS 123(R), Share-Based Payment, in December 2004 which requires expensing of employee stock options at the beginning of their next fiscal year after June 15, 2005.

The major features of APB 25, FAS 123 and FAS 123 (R) are presented on page 156 of the required reading. Please try the basic questions to test your knowledge on this subject.