Accounting for Employee Stock Options (ESOs) has been one of the most controversial topics in financial reporting during the last decade. Many employees receive equity compensation as a supplement to their salaries. Traditionally, this compensation comes in the form of ESO grants. This article describes employee stock option mechanism and underlines the rationale for ESO grants. It also explains how ESOs differ from ordinary call options. In recent years, accounting scandals (e.g., Enron, Tyco and WorldCom) created an environment that demanded more transparent and higher quality financial reporting. Subsequently ESO grants and accounting methods came under increased scrutiny by regulators.

Financial Accounting Standard (FAS) 123R is the new standard introduced by the Financial Accounting Standards Board (FASB), which requires companies to expense ESO in their income statements using fair value method. FASB sets Generally Accepted Accounting Principles (GAAP) in the US. Till now companies continued to use intrinsic value method for ESO valuation and did not expense it. Beginning January 1, 2006, it was made compulsory under US GAAP to expense ESOs in income statement to enhance transparency in financial reporting. Indian GAAP does not require companies to expense ESOs in income statement. However, expensing ESOs enhances transparency in financial reporting and improves corporate governance standard.

An option is a contract which gives its holder the right to buy (or sell) an asset (e.g., a stock or a bond) at some predetermined price within a specified period of time. Having rights without obligations has financial value, so option-holders must purchase these rights, making them as assets. These assets derive their value from some other assets. Thus, they are called as derivative assets. Payment for call and put options, takes the form of a flat, up-front sum called a premium. There are two basic types of option contracts: Call Options and Put Options.

The Accounting World Magazine, Employee Stock Options, ESOs, Financial Accounting Standard, FAS, Generally Accepted Accounting Principles, GAAP, Derivative Markets, Corporate Governance, National Center for Employee Ownership, NCEO, National Compensation Survey, International Accounting Standards Board, IASB, Financial Executives International, FEI.