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Become a day trader. Dilution - Part 1 ESOs: Dilution - Part 2 ESOs: By David Harper Relevance above Reliability We will not revisit the heated debate over whether companies should "expense" employee stock options.
However, we should establish two things. Despite political pressure, expensing became more or less inevitable when the International Accounting Board IASB required it because of the deliberate push for convergence between U. Second, among the arguments there is a legitimate debate concerning the two primary qualities of accounting information: Financial statements exhibit the standard of relevance when they include all material costs incurred by the company - and nobody seriously denies that options are a cost.
Reported costs in financial statements achieve the standard of reliability when they are measured in an unbiased and accurate manner.
These two qualities of relevance and reliability often clash in the accounting framework. For example, real estate is carried at historical cost because historical cost is more reliable but less relevant than market value - that is, we can measure with reliability how much was spent to acquire the property.
Opponents of expensing prioritize reliability, insisting that option costs cannot be measured with consistent accuracy. This means that options cost estimates must be disclosed as a footnote, but they do not have to be recognized as an expense on the income statement, where they would reduce reported profit earnings or net income. This means that most companies actually report four earnings per share EPS numbers - unless they voluntarily elect to recognize options as hundreds have already done: On the Income Statement: Specifically, what do we do with outstanding but un-exercised options, "old" options granted in previous years that can easily be converted into common shares at any time?
This applies to not only stock options, but also convertible debt and some derivatives. Diluted EPS tries to capture this potential dilution by use of the treasury-stock method illustrated below. Our hypothetical company has , common shares outstanding, but also has 10, outstanding options that are all in the money. Diluted EPS uses the treasury-stock method to answer the following question: In the example discussed above, the exercise alone would add 10, common shares to the base.
However, the simulated exercise would provide the company with extra cash: Because the IRS is going to collect taxes from the options holders who will pay ordinary income tax on the same gain. Please note the tax benefit refers to non-qualified stock options. Let's see how , common shares become , diluted shares under the treasury-stock method, which, remember, is based on a simulated exercise. We assume the exercise of 10, in-the-money options; this itself adds 10, common shares to the base.
To complete the simulation, we assume all of the extra money is used to buy back shares. In summary, the conversion of 10, options creates only 3, net additional shares 10, options converted minus 6, buyback shares. But what do we do with options granted in the current fiscal year that have zero intrinsic value that is, assuming the exercise price equals the stock price , but are costly nonetheless because they have time value?
The answer is that we use an options-pricing model to estimate a cost to create a non-cash expense that reduces reported net income. Whereas the treasury-stock method increases the denominator of the EPS ratio by adding shares, pro forma expensing reduces the numerator of EPS.
You can see how expensing does not double count as some have suggested: While the proposed accounting rule requiring expensing is very detailed, the headline is "fair value on the grant date".
This means that FASB wants to require companies to estimate the option's fair value at the time of grant and record "recognize" that expense on the income statement. Consider the illustration below with the same hypothetical company we looked at above: However, under pro forma, the diluted share base can be different. See our technical note below for further details. First, we can see that we still have common shares and diluted shares, where diluted shares simulate the exercise of previously granted options.
Second, we have further assumed that 5, options have been granted in the current year. Third, since our options happen to cliff vest in four years, we will amortize the expense over the next four years.
This is accounting's matching principle in action: Although we have not illustrated it, companies are allowed to reduce the expense in anticipation of option forfeitures due to employee terminations.
We divide this into both common shares and diluted shares to produce the second set of pro forma EPS numbers. These must be disclosed in a footnote, and will very likely require recognition in the body of the income statement for fiscal years that start after Dec 15, Technically, under pro forma diluted ESP item iv on the above financial report , the share base is further increased by the number of shares that could be purchased with the "un-amortized compensation expense" that is, in addition to exercise proceeds and the tax benefit.
Remember, this only applies to the pro forma diluted EPS where we are expensing options in the numerator! Conclusion Expensing options is merely a best-efforts attempt to estimate options cost. Proponents are right to say that options are a cost, and counting something is better than counting nothing. But they cannot claim expense estimates are accurate. Consider our company above. Then the options would be entirely worthless, and our expense estimates would turn out to be significantly overstated while our EPS would be understated.
Conversely, if the stock did better than expected, our EPS numbers would've been overstated because our expense would've turned out to be understated. Investors need to be aware of dilutive securities and how they can affect existing shareholders. Share dilution reduces the value of an individual investment and can drastically impact a portfolio.
There are times when an investor shouldn't exercise an option. Find out when to hold and when to fold. A look at the five varieties of EPS and what each represents can help an investor determine whether a company is a good value, or not. Stock options can be lucrative for employees who know how to avoid unnecessary taxes. But is there another solution? Find out if management is doing its job of creating profit for investors.
Options are valued in a variety of different ways. Learn about how options are priced with this tutorial. Warren Buffett attended multiple prestigious schools on his path to success, but he places much more significance on real-world Chapter 7 bankruptcy is sometimes called liquidation bankruptcy, while Chapter 11 bankruptcy is called rehabilitation bankruptcy.
Corporations sometimes issue shares with no par value because it helps them avoid a liability should the stock price take Get Free Newsletters Newsletters.More...