A theoretical analysis of recent developments on accounting standards for stock options and a practical application to Cisco Systems, Inc. as an illustration.
Abstract This paper analyzes developments in the accounting field for stock options regulating standards. The writer shows how the accounting technique caused huge controversy among regulators and academics with respect to the treatment of stock options in the financial statements because the primary objective of decision usefulness of financial reporting as well as net income depends on whether or not the company recognises stock options as expenses on a fair value based method in the income statements. It argues that although the recent developments of the accounting standards proceed in the right direction, there are still issues that must be addressed. It shows that in order to solve the remaining issues, it is necessary to improve the qualitative aspects of financial information, such as relevance, reliability and comparability which directly relate to the primary objective of financial reporting.
1 Introduction
2 Historical Developments on Accounting for Stock Options 2.1 APB 25: Intrinsic Value
2.2 SFAS 123: Introduction of Fair Value Based Method
2.3 SFAS 148: More Timely and More Prominent Disclosure
3 Theoretical Analysis
3.1 Fundamentals of Financial Reporting
3.1.1 Objective of Financial Reporting
3.1.2 Qualitative Characteristics of Accounting Information
3.2 Recognition of Expense
3.2.1 What Is an Expense?
3.2.2 Assets under SFAC 6
3.2.3 Liabilities under SFAC
3.2.4 Assets under Exit Value Accounting
3.2.5 Liabilities under Exit Value Accounting
3.2.6 Comparison of the Recognitions
3.3 Measurement
3.3.1 Fair Value Method
3.3.2 Intrinsic Value Method
3.4 Summary of Theoretical Analysis
4 Practical Analysis - Cisco Systems, Inc.
4.1 About Cisco Systems, Inc.
4.2 Applications to the Accounting Standards
4.3 Pro Forma Disclosure in the Profit and Loss Statement
4.4 Market Share Price and Employees Stock Option Incentives
4.5 A Need for Change
5 Conclusion
6 Bibliography
Appendix
From the Paper "High-tech companies such as Cisco Systems have developed as major global business players during the last decade. One of the devices that many of these companies often applied in the process of their economic growth was a stock-based compensation plan. Such small venture businesses, which were normally deficient in cash in their initial stages, provided employees with the right to purchase their own stocks instead of cash. As a result, stock options could enormously reduce the amount of cash and wage expenses at the same time. Further, entrepreneurs could effectively retain talented staffs by granting them stock options, and could elevate motivation among the employees. However, the series of frauds and corporate crisis over the past year raised the question of accounting treatment for stock options whether the present standards achieve the principal objective of decision usefulness of financial reporting."
Abstract This paper discusses employee stock option programs and FASB (Financial Accounting Standards Board) accounting requirements The paper includes recent changes that now treat options as expenses. It mentions the use of stock options as a reward for employees and executives.
From the Paper "For many years stock options provided companies with a key tool used to reward employees and executives. Beginning in the stock options became an increasingly popular way for companies to tie corporate performance ..."
Abstract This paper looks at stock options and compensation packages and some of the problems raised as well as comments from those supporting this approach, noting the recent rule changes that will also change how employees are compensated with stock options, an addition to base pay and only one of the other means of pay that are used to motivate, recruit and reward.
From the Paper "Compensation packages are a means by which companies can achieve several different goals related to recruitment, retention, and motivation, among other things. Such packages are constituted in a variety of different ways, and one issue that has been raised is what role stock options should have and how effective they are in the compensation package. The question is also asked as to whether they serve the needs of the company and the employee alike or favor one over the other. In terms of the general issue, of compensation, Molvig (2005) states, Executive compensation never involves just one element. Boards must look at every piece of the package to determine if it furthers the goals of the CU and the executive (para. 1). Compensation is not the only element in recruitment and retention, however, and surveys show that while important, compensation is not necessarily the most important factor. "
Abstract This paper discusses how all the US Federal Agencies are legislatively bound by decision-making with benefit-cost analysis techniques at a time when they are under increasing pressure to prove the effectiveness of their spending and better accommodate uncertainty. Collectively these Agencies were responsible for making decisions on how they spent $2.5 trillion in fiscal year 2005, of which $1 trillion was for discretionary spending. This research identifies, through a case study of Federal Aviation Administration decision-making for a system within a complex system, how real options thinking can be acceptably and effectively appended to current mandates for benefit-cost analysis defined by the Office of Management and Budget in Circular A-94.
From the Paper "In the work of de Neufville and Wang (2004) it is stated that: "Most real options are not well-defined simple options. They can be compound or parallel. Compound options are often options on options, and the interactions between them are significant." (Neufville and Wang, 2004) Further stated is that: "Parallel options are different options built on the same project, such as the several possible applications or target markets of a new product." (Neufville & Wang, 2004) de Neufville and Wang (2004) categorize 'real options' as "those that are either 'on' or 'in' projects."
Abstract This paper explains that a lookback option is path dependent, based on the maximum or minimum underlying value reached during the entire life of the option. The author points out that, at the expiration date of these options, the holder may "look back" over the life of the option and exercise it, based on the optimal underlying value achieved during that period thus giving the holder the ability to buy an asset at its lowest price or sell it at its highest price achieved over the life of the option. The paper relates that, through the lookback option, the investor can achieve economic intelligence and value through the benefit of hindsight; however, lookback options carry risk and are more expensive than standard options. The paper includes several formulas.
Table of Contents
Definition of Options Call and Put Options Introduction to Lookback Options Lookback Options in Greater Depth
The Model
Option Pricing
Discrete Lookback Options Case Study of Lookback Options
From the Paper "Put options conversely involve the investor aiming for a stock price decrease. The put option, as mentioned in the introduction, allows the holder to sell an asset by a particular date for a certain price. An example demonstrated by Hull (2006) involves a European option involving an investor who buys the option to sell 100 shares with IBM for a strike price of $70. If the current stock price is $65 and the expiration date is in three months, Hull supposes for example that the option to sell one IBM share is $7. The initial investment, therefore, will be $700."
This paper discusses stock options, a contract offered by the employer that gives an employee the right to buy or sell a certain number of shares in the company at a specific price within a certain period of time.
Abstract This paper explains that stock options have been hailed as a great way to share ownership, attract and retain employees in a tight labor market, and "fuel the entrepreneurial fire?; but, at the same time, they have been condemned as a major cause of the high-profile business scandals during 2000-01 and the subsequent down-turn in the U.S. stock markets.
The author points out that another attraction of stock options from the employees? point of view is that the only capital gains tax is applicable on gains made from stock options. The paper relates the future of stock options does not appear bright because of accounting changes requiring firms to reflect the cost of stock options in their earnings as expenses by 2005.
Table of Contents
What are Stock Options?
History of Stock Options Advantages of Stock Options Disadvantages
Future of Stock Options
From the Paper "Stock options first began to appear in the US businesses in the 1950s, but at the time they were generally modest in size. The trend of offering stock options (particularly to the top managers) began to take off in the late 1980s and by the turn of the century the typical CEO of financial sector firm was receiving stock options worth $55 million a year?more than 30 times his salary. (Shapiro, 2002). The offer of stock options became more widespread and the NCEO estimated that as of 2001, up to 10 million employees were receiving stock options in the US."
Abstract This paper defines exotic options and its variation, digital options, which are also referred to as binary or all-or-nothing options. Specifically, the paper demonstrates ways, including formulas, to price these options using the Black-Scholes, cash-or-nothing (CON) or asset-or-nothing econometric models. After investigating the advantages and disadvantages of digital options, the paper concludes that exotic options help investors find the best solutions for their problems as well as for their strategic financial planning.
Table of Contents:
Introduction
Description
Types of Digital Options Correlation Digital Option Pricing
Black-Scholes Model
Cash-or-Nothing (CON)
Calculation Example
Asset-or-Nothing
Target Market
Advantages
Disadvantages
Conclusion
From the Paper "For companies that want to invest, there is a huge variety of financial products on the market to choose from. One type of security is the so called option. For sophisticated investors the opportunities are various, however risks for non-specialists can also be extremely high. The following definition simply explains what an option is. ...
"There are many kinds of options. They range from very speculative to rather conservative. First options are differentiated between American and European options."
Tags: risks, fixed payout profile, payout ratio, distribution hedge
Abstract This paper discusses the history of trading options on the stock markets. The different types of options are outlined and explained. A detailed introduction of the decimalization system is presented, including a look at the impact it has had on the options market in general. The paper examines the variety of reasons why decimal pricing is beneficial for individual investors. The paper claims that options have remained popular throughout history because they tend to provide a bigger return on a smaller investment.
Introduction
About Options Background
Put and Call Broker's Association
Before Decimalization
Impact of Decimalization
The Problem with Fractions
Decimalization
Changing the Option Market
The Basics of the History of Options Employee Stock Options Conclusion
Works Cited
From the Paper "An option provides investors with the right to buy or sell a particular contract at a specific price within a certain period of time (Ruffy, 2002). An option is a legally binding contract that is traded on one of the commodity exchanges. If the option is a call option, the buyer or holder has the right to buy the number of shares stated in the contract at the strike price. If the option is a put option, the buyer of the option has the right to sell the number of shares stated in the contract at the strike price. The holder or the buyer does necessarily not have to exercise this right. Therefore, on the expiration date of the contract, the option may be exercised at the discretion of the buyer. On the other hand, in a futures contract, the two parties to the contract commit to a deal at a future date. To have this privilege of doing the transaction at a future only if it is profitable, the buyer of options has to issue a premium to the seller of options."
Abstract This paper focuses on the current employment environment and the continue willingness of employees to take stock options in a currently depressed market. A stock option is a promise by the grantor to sell a share of stock at a pre-agreed price. It looks at how the technology sector had been at the forefront of the use of stock options as a means of employee compensation during most of the 90s and how, in the current market, there is still the hope that, sooner or later, the market will eventually rebound. It shows how, by accepting stock options as part of their compensation package, employees are gambling that they would eventually profit, hopefully handsomely, by being able to exercise their stock options sometime in the future.
Outline
Introduction
Stock Options ? An Overview
Why Companies Offer Stock Options Why Take Stock Options Today?
From the Paper "An accounting glitch makes offering stock options especially enticing for company accounts as well. As stated, stock options are benefits granted to company employees with the promise that they can buy a specific number of shares of stock after a certain period of time at a price specified at the time the options are issued. So, if the stock exceeds that price, which was often the case in the 90?s, the employee kept the difference, in other words, made a nice profit. The nice thing for the companies is that at the same time that the employees exercise their stock options, the company can take a tax deduction when the options have been exercised. This allows companies to reduce their taxable income considerably thus trimming corporate tax bills."
A look at accounting treatment of employee stock options, the benefits and disadvantages of stock options and present legislation of employee stock options.
Abstract This paper discusses the practice of issuing employee stock options as a benefit. The paper goes into detail about how a stock is exercised and what kind of tax benefits result. The paper also details past practices of accounting employee stock options and how these practices have worked. Also included in the paper, is information on present legislation and how that works or doesn't work to better the situation. Furthermore, the paper discusses the controversy brewing over such changes being made and explores the different viewpoints on the matter.
Introduction
Definition
Methods and Models
Controversy of Stock Options Baseline: Americans with Stock Options Recent Legislation
Economic Impact
High Tech Industry
The Cisco Company
Why Employees with Stock Options Should Worry About Valuation
From the Paper "Within the last ten years a demand for changing how Employee Stock Options (also referred to as ESOs) are accounted for within an organization's financial sheets has been underway. Such a proposal for change has received much commentary from not only the financial community and corporate America but also key members of Congress, union leaders and the public. Such a response results from the uncertainty that such change will benefit businesses and economic growth in this country. It is feared that such change will have the opposite effect and cause America to lose its competitive edge in the global market. Still this has not stopped the fuel of the fire as the Financial Accounting Standards Board (also referred to as FASB) has struggled for an answer to such a dilemma."
Abstract While the Financial Accounting Standards Board has favored expensing stock options since the mid-1990s, it has continued to allow businesses to recognize the expense in footnotes to financial statements as an alternate reporting method. Recent publicity around accounting fraud, executive abuses, "cooking the books," and other questionable business ethics has focused increasing attention on stock option plans in the United States. Prior to the introduction of the Black-Scholes formula, options investors determined a risk premium to hedge against major financial losses. According to the Black-Scholes formula, risk premiums are not necessary for investment in stock options because such premiums are already factored into the prices of stocks. This paper provides an overview of how the Black-Scholes formula can be used to help investors better understand the forces at play in making decisions about stock options, followed by a summary of the research in the conclusion.
From the Paper "While Merton's research covered many areas of finance theory and economics, his innovations in option valuation has perhaps been his most influential to date (Bernstein, 2000). Prior to 1973, when Black and Scholes published their precedent-making formula, determining the value of stock options was considered extremely risky and highly difficult because of the nature of options, which are essentially agreements that give investors the right to either buy or sell an asset at some fixed time in the future (Crum & Goldberg, 1998)."
Abstract This paper explains that the Real Option Valuation technique, which involves the prediction of the returns with an assumption that the asset valuation is closely connected to the management of assets, is an alternative over the discounted cash flow technique. The author clarifies that the Real Options Valuation technique emphasizes the value of the flexibility of the management while making decisions during the operation of the project; thus, it integrates the strategic planning options, such as to include, defer, abandon and other choices, which prevents committing error decisions. The paper relates that a weakness of the Real Options Valuation approach is that it neglects the influence of other parties.
From the Paper "The terminology, Economic Value Added, is also used to mean the economic profit. A positive economic profit indicates greater returns of the company over the cost of capital. In order that the company operates with a real profit it should be ensured that the returns are more than the cost of capital conversely it leads to loss. The long term investments are associated with uncertainty, and therefore necessitate firm decision making techniques analyzing and estimating the probability of outcomes taking and the values of these expected outcomes. Even though the firm managers try to put all their efforts for reducing risk taking assistance of the best possible information available, the uncertainty of weather and markets cannot be avoided. This makes essential the firms to depend upon the various decision making techniques while making strategic long term investments."
Tags: prediction, valuation, assets, flexibility, capital
Abstract The paper describes how most investors look at options as useful tools of risk management and use them as protection against a drop in share price. The paper further explains how hedging through options helps a person to manage risk, yet, it is important to remember that all investments carry some risk, and returns are never guaranteed by any investment. The writer concludes that options permit individuals to see their dreams in a much larger scale than their pocket would permit them than if they were to invest in the stock market, making options a cheaper alternative to stocks.
From the Paper "Some suggest that a method could be for the employee to take positions in other securities so that the risk will be evened out. The best possible hedge is to short sell the stock that the employee is expected to get, and then if the stock price falls, then the loss in the value of options will be made up by the gains from the short sold shares. At the same time, this is an important method to earn money and the Securities and Exchange Commission has now forbidden that officers and directors short sell their own shares, but this can be done by the lower level employees still."
Abstract This paper defines a conventional mortgage as a long term loan which meets the guidelines put forth by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp. This paper details the three types of conventional mortgage options currently available. The first is the fixed rate conventional mortgage, the second is an adjustable rate conventional mortgage while the third is a balloon mortgage. This paper examines the characteristics of the three mortgage options. This paper focuses on the debt problems of a particular hospital while attempting to find the most cost effective mortgage option to reduce said debt. This paper also analyzes the risks involved in securing a conventional mortgage by delving into the various issues surrounding the workings of state and local hospitals. The writer contends and explains why hospitals are generally insecure financial institutions dependent on state budgeting and financing which can and usually are influenced by issues such as changes in the governing party or changes in the state's priorities.
From the Paper "If we look at these three types of conventional mortgages and the characteristics each bear, as compared to the needs of hospital, the most suitable seem to be the fixed rate conventional mortgage and the balloon conventional mortgage. There are several reasons for this.
First of all, for a hospital, the budget is generally set ahead for a period of several years. In this sense, financial stability and a clear sense of what needs to be made in the next period of time is most important. If we consider the adjustable rate conventional mortgage, for example, it may occur that somewhere in the 10th year, the monthly rate, including interest rate, will suddenly double its value. It is, in this sense, a question of security and risk avoidance."
Tags: finance, hospital, debt, long, term, loan, bank, mortgage, politics
Abstract This paper provides a comprehensive review and discussion of the relevant literature to define what stock options are and how they are used. An examination of traditional and new valuation methods is followed by a review of current and future trends in expensing stock options. A summary of the research is provided in the conclusion. Two excellent graphics are also provided within the text.
From the Paper "During the past decade, American corporations have granted more and more stock options as compensation, especially for top executives. An option gives the holder the right to buy or sell stock at a specified price by a specific date. If the right to buy shares is set at a low price and the stock goes up, the option holder makes a profit. Critics of the proposed changes argue that options provide vital incentives for skilled employees and executives, especially those who work for risky high-tech ventures. Advocates of reform maintain that options give executives too much incentive to inflate profits falsely to boost the value of their options. Also, they argue that because stock-option costs are not counted in quarterly earnings statements, companies can mask their true cost to investors."
