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, treating options as 90 day options that are extended quarterly, that addresses these legitimate objections. The costs of both new options and the extension of old options are expensed at fair value on the day recognized. As a consequence, all expense recognition produce the same risk-adjusted present value of expected costs. This enables us to allow firms some flexibility in choosing a recognition schedule that mirrors their own labor practices. The system produces objective, transparent, and decision-relevant information.