By Graeme West, Financial Modelling Agency
Employee or executive stock options (ESOs for short) are call options granted by a company to an employee on the stock of the company. These options are part of the remuneration package of the employee. However, they differ from ordinary options in at least one crucial way: they cannot be transferred, and in the event of the employee leaving the company, they are forfeited.
They are a sweetener for the employee: they encourage him or her to remain an employee, and they encourage him or her to work towards an increase in the financial health of the company, which will translate into an increased share price, and eventual increased wealth of the employee.
A very brief history of valuation questions
Until the birth of option pricing algorithms in the 1970s the common wisdom concerning ESOs was that they were not an expense because there were no cash flow implications for the firm. The first valuation methodology to be introduced was that options should be expensed at their intrinsic value on grant date. Provided that these options were granted at the money, which was typical, there would be no profit and loss or bottom line effect.
It is important to note that the value of the asset that the individual employee stock option holder has is not equal to the liability of the company.
In the 1990s it was recognised that options, even those struck at the money, had economic value, and thus needed to be expensed. However, very few companies chose to record any expenses for their ESOs, especially when there was no legal or regulatory requirement for such accounting treatment. In the USA for example, the Financial Accounting Standards Board only made footnote disclosure of such expenses mandatory, and because of this many companies did not record the impact of their ESO’s, further than referring to it in a footnote to their financial statements.
After the dotcom crash, it was realised just how much of a burden ESOs were to the company. Many dotcom companies had relied very heavily on ESOs to incentivise employees, and these companies would have looked unprofitable a long time before they actually did, if those ESOs had been expensed, rather than just appear as footnotes to the accounts.
It is now almost universally accepted that ESOs are an expense to the company that need to be accounted for - see Bodie et al. . Audit requirements for ESOs fall under IFRS2 IASCF  regulations. The company is buying services from the employee; the remuneration is share-based. As such this remuneration needs to be expensed using a recognised option pricing formula.