Expensing Options Is Bad Accounting?

Just when I thought the debate was over, it has been re-opened as several accounting experts have claimed that expensing options is bad accounting. Here is the logic:

  • An Employee Stock Option (ESO) is a "gain-sharing instrument" in which shareholders agree to share their gains (stock appreciation), if any, with employees;
  • A gain-sharing instrument, by its nature, has no accounting cost unless there is a gain to be shared;
  • The cost of a gain-sharing instrument must be located on the books of the party that reaps the gain;
  • In the case of an ESO, the gain is reaped by shareholders and not by the enterprise; so the cost of the ESO is borne by the shareholders;
  • This cost to shareholders (which, coincidentally, exactly equals the employee's post-tax profit) is already properly accounted for under the treasury stock method of accounting (described in FAS 128, entitled "Earnings per Share") as a transfer of value from shareholders to employee option holders;
  • Neither the grant nor the vesting of an ESO meets the standard accounting definition of an expense. Moreover, ESOs can be granted only to employees, are not transferable, and are cancelable at the will of the company (by terminating the employee). Consequently they cannot be sold on the open market. And to sell them to employees defeats their purpose. Thus, companies do not forgo any cash when they grant ESOs, so their issuance cannot be an opportunity cost.

I don't get it. If I give an option to my employee at a $15 strike price and six months from now he cashes it in when the shares are $20, all I've done is raise capital in an inefficient way. How is that good for anybody other than the employee? That $5 difference is a real economic expense.