Loopholes in Accounting for Employee Stock Option

In the beginning of the year 2006, the organization (the Financial Accounting Standards Board, FASB) that makes sure the rules that corporations must record their profits and losses are followed decided that the cost of employee stock must be included in the financial statements of the companies in question. Before this rule was endorsed the company managers had a choice to either include the cost of options or not. Most of the companies chose not to include thus creating what can be termed as free ride which has been frowned by many investors.

(Constable) By closing the loophole many experts would say that no one will get a free ride. This is not actually wrong because what goes on in accounting is the estimated value of the options. Companies are usually allowed to calculate a theoretical expense or cost estimate using the variety of techniques available. Estimates are fine because they are used all the time in financial statements. For instance in revenue when a sale is booked and adjustment is made what is known as the allowance for doubtful accounts.

If the estimate which was made is high then the allowance is reversed. These adjustments which are made after the facts have come up are referred to as true-up. The true-up is of importance because the estimates are often wrong. They also ensure that the accounts of a company accurately reflect the financial picture of what exactly happened. (Constable) When there are options there are no true-up. When the options expire unexercised and worthless, the cost still remains in the profit and loss. It is therefore an expense when there is no cost.

Also when the company stock does gangbusters and the employee option holders become rich then there is no increase in expenses (accounting cost). This is the loophole that remains. Also the stock options that are offered by internet giant’s executives during a public initial offer are likely to be lower than the actual cash that the executives receive thus creating another loophole. (Financial Accounting Standard Board) Enron Company as well as other companies rely on loopholes in accounting rules in order to keep its liabilities hidden in offshore partnership and in off-the-bo0ks.

The company has been using the loopholes to make their accounting statements portray what they want them to portray. This company used political muscle to exempt its energy trading transactions which were complicated from oversight by the Commodities Futures Trading Commission, SEC or any other agency. This brings the need of the congress to make sure that all the material facts are disclosed clearly, all transactions including derivatives are regulated and not exempted by loopholes.

(Enron Watchdog) Enron Company used over the counter derivatives in order to be able to hide that nature of what it was doing to make money. Today many former employees, retirees and investors are paying the price of their company’s desire to operate confusing, murky and unregulated transaction. (Enron Watchdog) The stock option accounting loophole has caused misallocation of capital in favor of companies that understate their compensation costs.

It has also resulted in the over reliance on stock options at the expense of other forms of compensation which are executive which better align with the management interests with those of the shareholders. Many companies such as GAP Inc. have said that they are reluctant to use he stock options which are performance based which are indexed by their competitors. This is because indexed stock options must be expensed under the accounting rules which are workable at that specific time. (Constable)