Common Misconceptions About Employee Stock Options

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In their article “Employee Stock Option Valuation: New Source of Litigation Risk for Auditors” (Perspectives, August 2004), authors Cindy W. Ma, Algis T. Remeza, and Daniel LaGattuta posit a myth about employee stock option (ESO) valuation: that there is a disconnect between the value of option-based compensation to employees and the cost of the same compensation to the company. This is not the first time I have heard this distinction being raised, and its perpetuation is troubling.

In other corners of the valuation world, such controversies have long been addressed by privileging the concept that value is “value received.” For example, assume a company generates a technology that it cannot use. The company opts to donate that technology to an institute that needs it. In such a case, the technology is essentially valued for what it is worth to the ultimate user, not for its worthlessness to the donor. Similar logic applies here.

Furthermore, why would a company engineer a compensation system that costs the employer more than it benefits the employee? For a long time, ESOs were considered to be more or less costless to the company but of great value to the employee. Some apparently still think that way, but the general discrediting of that logic has led FASB to where it is today. Now we have the opposite and equally dysfunctional argument, that somehow ESOs are more economically costly to the company than they are beneficial to the employee. Conceptualizing a compensation expense to the company that is different from the value received by the employee violates the spirit of SFAS 123.

The principle of equating compensation costs and benefits has led to changes in accounting standards; valuation of ESOs should recognize this symmetry.

Matthew R. Crow, CFA, ASA
Senior Vice President, Mercer Capital




















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