I disagree with your points # 2 and # 3.
mindmeld, you disagreeing with those two points is not surprising. Remember, I said "only some people know about" #2, and "very few people know about" #3. :-))
In general, the grant and the exercise are two separate economic events in the life of the option. (Well, there is the trivial expiration event also.) Point #2 addresses the grant , and #3 addresses the exercise.
As for #2, the grant looks like the gift of a call option from the company to the employee. I say 'looks like a gift', because many of us see no money changing hands. But the reality is that there were two property transfers, cash flows if you will permit, that produced a net cash flow of zero. The call option has a value as evidenced by options trading on the CBOE. It's called an option premium on the open market. So what actually happened is the company gifted the option premium to the employee, and the employee used the gift to buy the call option.
In 1993-94 the FASB drafted a proposal that later became SFAS 123. The FASB wanted companies to expense the option premium. Companies, especially technology companies, raised such a ruckus, somehow the issue ended up in front of Congress. Lobbyists convinced Congress to force the FASB to water down SFAS 123. Companies then had the option of using either the "intrinsic value method" or the "fair value method" of placing a dollar value on the stock option that would be used in the financial reports.
Well, the intrinsic value of the option on the grant date is zero, i.e., zero expense. (The option exercise price is usually the market price on the grant date, and the intrinsic value on any date is the difference between the market price and the exercise price.) The "fair value" is based on a variant of the Black-Scholes option model, which "fair value" can easily be 50% of the market price on the grant date. Guess which one most companies choose?
The FASB knew that would happen. So they required, for companies that chose the intrinsic value method, the option grant expense be reported in the footnotes. And it has been ever since.
A loophole? Exactly. It's a loophole Senators Carl Levin, John McCain etal are trying to fix with Senate bill S.1940. But just because a loophole allows a company to not report an expense on its GAAP financial reports to shareholders, doesn't mean it is not an expense.
Additionally, the option grant expense has nothing to do with earnings dilution. Earnings dilution is a different cost to shareholders. The grant sets the stage for potential dilution. Actual dilution occurs when the option is exercised. In the interim, the company reports the impact of the expected dilution as "diluted EPS".
We have two different events, and two different times. The first is an expense to the company, the second is a cost to the shareholder.
If and when we dispense with #2, we can discuss #3.
Ron |
