Panel 1: Accounting

Fordham Journal of Corporate & Financial Law, 2003 by Raymar, Steven, Finnerty, John, Zwecher, Michael

PROFESSOR RAYMAR: Thank you, Alan. Thank you, Law School. I am very pleased to be here and leading this first panel.

I think the policy I am going to follow right here is to start off with my presentation. I am a Finance Professor at Fordham. I have had some experience-working on a paper and a little bit of consulting-with employee stock options. I would like to introduce my esteemed co-panelists up here. I am Steve Raymar. To my left is John Finnerty. To his left is Mike Zwecher.

I am just going to be fleshing out some of the basic issues that have to do with employee stock options. They have been in the news a lot of late. From what I have read, I often learn a little bit when I am reading the articles, but I am often more concerned about the fact that much that is of interest is not there.

The four sub-topics here are: what are employee stock options; how are they accounted for and taxed; some survey data on option usage; and some issues in employee stock options.

Now, just so we do not misunderstand my expertise here, I am a finance professor, I am not an accounting professor, and I am certainly not a tax expert, so if anyone wants to correct me as we are going along, feel free.

What are employee stock options?

Well, first of all, they are call options. If you do not quite know what a call option is, we will get to that on the next page. Typically, these call options have a ten-year life; they vest over a three- or four-year period. If an employee leaves the firm, they are forfeited, or if they are in the money, the employee can exercise them at that time.

The three basic varieties are: non-qualified stock options, two types; and then, tax-qualified, a third type.

* The first type, and by far the most common, are simple, fixed-price call options.

* The second are variable-price options, also called in the newspapers "incentive stock options."

* A third type is "incentive stock options."

I learned a little bit visiting Mike about three weeks ago, and then, upon some further reading, realized that there are two types of incentive stock options: those that are so-called "tax qualified" and those that are not.

So there are three basic types.

This next formula provides a simple illustration of a call option payoff.

When it expires, or when the owner of the option wants to exercise that option, this is the payoff that would be achieved.

So, for instance, if the exercise price, meaning the price at which the owner of the option exercises the option and receives in turn the stock, denoted in the equation as X, is $55 and if the stock price happens to be $75, the employee can purchase that stock for $55 and have a gain of $20. That is called "in the money."

If the option is out of the money, that means the stock price is below $55, in which case it is not worthwhile to exercise that option.

"Exercise" that option means pay the $55 and get the stock. So an employee would achieve that immediate $20 payoff if the option is exercised.

Below is an explanation of the Black-Scholes Call Option Pricing Formula.2 It is really not that hard, or that difficult. I am not going to take everybody through it, and I am not going to fill in the gaps of what is not here.

For this presentation, let's just say that N(d^sub 1^) and N(d^sub 2^) are roughly probabilities of the option finally being in the money-in other words, the option stock price finally being above $50.

That is a simple way to present it. So the value of the call is in some probability related to the stock price minus the present value of the exercise price, again multiplied by some probability, and that gives you the call price. It is really not that difficult to deal with in any kind of computational sense.

On the question of "Is it accurate with respect to employee stock options?" John is going to lecture on that in a little while.

How are Employee Stock Options accounted for? Well, first of all, let's start off with a FAS 1233 illustration. FAS 123 is the accounting rule that is being written about and talked about so much of late, and I thank Professor Pat Williams for this little example.

Let's suppose that on January 1, 2000, these options are granted. There are 900,000 of those options given to 3,000 employees and they vest over three periods, just to keep it simple, and the expected option life is six years. Even though they may have a ten-year expiration date, we are assuming the expected option life is six years. The expected yearly forfeiture is 3 percent. The stock price when granted and the exercise price are both $50. The interest rate is 7.5 percent. Volatility is an estimate of the standard deviation of stock rate of return, 30 percent; and dividend yield is 2.5 percent.

Before we pass on here-the stock price when granted $50, exercise price $50-if you think about that previous diagram, what that means is that the immediate payoff value is zero, because the option has an immediate payoff value if the stock price is above the exercise price. So this has an immediate payoff value of zero, and that permits favorable accounting from the corporation's perspective. The Black-Scholes value here would be $17.15 per option.