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An estimated 12 million US workers own employee stock options, giving them the right to purchase shares of stock in the future, usually at an attractive price. Is this a benefit to employees? That is at the heart of a major controversy between accounting standards setters and corporate management which has centered on whether stock options should be treated as part of compensation expense. Of course, the majority of these shares are provided as incentives to management. The theory being that if the company does well, they do well.

Several years ago when the Financial Accounting Standards Board (FASB) was looking at stock options, corporate management lobbied successfully with the help of a threat of Congressional intervention to keep accounting standards from requiring expensing stock options as part of compensation expense. While there are currently no standards for expensing stock options in the rest of the world, U.S. accounting standards do require expensing most stock options with the exception of the one type used most extensiely by corporations to remunerate management and other employees.

Are these options free to the company or do they carry future hidden costs for investors? When reading a financial statement, it is important to understand from the note disclosures all the ramifications that the outstanding stock options could pose for the company.

Stock options gained importance in the 80s and 90s as shareholders pressed executives for better performance and Congress capped the tax deductibility of executive compensation not directly tied to incentives that benefit shareholders. Options became the compensation award of choice because they satisified existing constraints and have continued to be tremendously important to many companies in enlisting employees at all levels to think and act like shareholders. Venture investors view stock options as an essential ingredient to establishing the risk/reward ratio needed to attract essential management talent. Public companies, especially small to medium-sized ones, continue to feel very strongly that stock options are vital to their entrepreneurial culture.

The controversy surrounding stock options has moved in and out of the public policy arena when publicity increased about executive stock awards and particularly when the SEC investigates a company for misleading financial statements. There is an increasing concern that the incentives to keep stock prices high during times when stock options are exercised lead corporate executives to bolster stock prices through overaggressive accounting practices.

Companies argue that expensing stock options would overstate their economic cost in the financial statements and incorrectly curtail their use. They also believe that stock option charges against earnings would have also jeopardized initial public stock offerings. Younger, growing companies use options as a way to lure employees away from higher paying, more stable jobs. High-tech, biotech and restaurant companies would be affected, in particular, since they typically rely on options to attract employees.

Most public companies that use the “disclosure-only” alternative in their accounting resulting in zero compensation expense for those employee stock options issued with an exercise price equal to the market price on the date of grant. Those companies that do not recognize expense are required to disclose the effect of a “fair value” expense charge on net income and earnings per share in the financial statement notes.

A problem that has also arisen because of proforma earnings in companies’ press release do not disclose stock options’ potential affects on earnings and ownership dilution. . As an expense of doing business, options should be properly reported in a company’s income statement and as an investor you should look closely at a company’s policy for accounting for them and the expense associated with them disclosed in the notes.