CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

PAPER

APRIL 2004

Accounting for

Employee

Stock Options

CBO

Eyewire/GettyImages

The Congress of the United States O Congressional Budget Office

CBO

Accounting for Employee Stock Options

April 2004

A

PAPER

Preface

In March 2003, the Financial Accounting Standards Board (FASB) began reconsidering the 

accounting standard for equity-based compensation. The accounting board released an exposure draft for a revised standard on March 31, 2004. That revised standard would require 

firms to recognize the fair value of employee stock options as an expense, as was first proposed 

by FASB more than 10 years ago. 

This Congressional Budget Office (CBO) paper assesses whether, under the current accounting standard, firms that grant employee stock options without recognizing an expense overstate their reported income. The paper presents the relevant issues, describes the current 

standard for employee stock options, compares the intrinsic value and fair value methods of 

measurement, and weighs the potential economic effects of revising the current standard. The 

report was prepared at the request of Congressman Brad Sherman in his capacity as a member 

of the House Committee on Financial Services.

Judith S. Ruud of CBO’s Microeconomic and Financial Studies Division prepared the paper 

under the direction of Roger Hitchner and Marvin Phaup. Early investigation of the subject 

was conducted by Douglas Gruener, a summer intern at CBO. George J. Benston of Emory 

University and Deborah Lucas of Northwestern University reviewed a draft of the paper and 

provided valuable suggestions. Wendy Kiska, Angelo Mascaro, David Torregrosa, Philip 

Webre, and Thomas Woodward, all of CBO, also provided helpful comments. 

Christine Bogusz and Leah Mazade edited the paper, and John Skeen proofread it. Maureen 

Costantino prepared the paper for publication and designed the cover, and Annette Kalicki 

produced the electronic versions for CBO’s Web site (www.cbo.gov).

Douglas Holtz-Eakin

Director

April 2004

Summary vii

The Key Issue: Intrinsic Versus Fair Value 1

The Current Accounting Standard 2

FASB’s Proposal 3

Why Firms Grant Stock Options 3

Potential Economic Effects of Fair Value Recognition 4

Valuing and Recognizing

Employee Stock Options 5

The Difficulty of Measuring the Value of

Employee Stock Options 5

When Should the Value of Employee

Stock Options Be Measured? 7

When Should the Expense of Employee Stock Options 

Be Recognized? 8

Comparing Accounting Alternatives: An Example 8

Granting Cash, Stock, and Purchased Call Options as 

Compensation 8

Granting Employee Stock Options in Lieu of

Equivalent Cash Compensation 10

Letting Options Expire or Exercising Them 11

The Bottom Line: Reporting Differences

Between the Two Accounting Methods 11

CONTENTS
CONTENTS vi

Tables

1. Comparison of Accounting Treatments for Selected Forms

of Compensation: Cash, Stock, and Purchased Call Options 9

2. Comparison of Accounting Treatments for Employee Stock Options 10

3. Comparison of Accounting Treatments for Employee Stock Options

at Expiration 12

Boxes

1. The Accounting Framework 2

2. How Employee Stock Options Differ from Call Options 6
Summary

Current accounting standards require firms to recognize 

as an expense (deduct from their income) the value of the 

compensation they provide in the form of employee stock 

options. For some types of employee stock options they 

grant, however, firms can choose how to measure that 

value. They can use the immediate-exercise value (intrinsic value), which is usually zero, or an estimate of the 

market value (fair value), which is almost always greater 

than zero. As a result, firms may assign a cost of zero to 

that portion of compensation made up of grants of employee stock options. That practice results in overstatement of reported net income. 

In March 2003, the Financial Accounting Standards 

Board (FASB), the private-sector organization that sets 

standards for financial accounting and reporting in the 

United States, announced that it would reconsider the accounting standard for equity-based compensation. On 

March 31, 2004, FASB released an exposure draft that 

proposes revising the standard to require—not merely encourage—firms to recognize the fair value of all employee 

stock options as compensation expense for financialreporting purposes. The prospect of that revision has generated considerable debate.

Some analysts argue that requiring firms to recognize as 

an expense the fair value of employee stock options is unnecessary or ill-advised. Underpinning those arguments 

are different assumptions about whether the information 

on fair value is currently transparent to users of financial 

reports.

Analysts who believe that information about fair value is 

adequately transparent consider it unnecessary to change 

the current standard. Although information about fair 

value is not reflected in net income, it is already available 

to investors in the notes to firms’ annual financial reports. 

(In those notes, firms must disclose the fair value of the 

grants of employee stock options for which they recognized the intrinsic value.)

Other observers maintain that recognizing the fair value 

of employee stock options is ill-advised because that information is not now transparent and making it so could 

have negative consequences. Recognition might reveal 

new information to investors that could drive down the 

stock prices of firms that grant employee stock options. 

That result could in turn damage the economy, some analysts argue.

Still other analysts oppose the recognition of the fair 

value of employee stock options on more basic grounds. 

For example, they assert that the value of those options 

cannot be estimated reliably and that recognizing an estimate of the expense would reduce the accuracy of reported net income. Others oppose recognition because 

they do not view the granting of employee stock options 

as an expense to the firm at all but simply a redistribution 

of equity.

The Congressional Budget Office’s (CBO’s) analysis of 

this accounting issue comes to the following conclusions:

B If firms do not recognize as an expense the fair value of 

employee stock options, measured when the options 

are granted, the firms’ reported net income will be 

overstated.

B Changes in the value of employee stock options after 

they have been granted as well as the exercising of 

those options are irrelevant to a firm’s income statement because they affect shareholders directly, not the 

firm itself. Specifically, they transfer wealth from existing shareholders to holders of employee stock options.

B Although complicated to calculate, the fair value of 

employee stock options may be estimated as reliably as 

many other expenses.

B Recognizing the fair value of employee stock options is 

unlikely to have a significant effect on the economy 

(because the information has already been disclosed); 

however, it could make fair value information more 

transparent to less-sophisticated investors.

Accounting for Employee Stock Options

For more than 50 years, organizations that set accounting standards have espoused the principle of measuring the fair value of employee stock options provided 

as part of a compensation package and recognizing that 

value as an operating expense. Businesses that adhere to 

that principle subtract the options’ fair value—the estimated amount for which the options could be bought or 

sold in a current transaction—from their revenue in determining their earnings, which are reflected on their income statements (see Box 1). The information provided 

by the income statements and by other financial reporting and disclosures is used by investors and others outside 

the firms who are seeking to assess their profitability.

Proposals to require firms to recognize the fair value of 

employee stock options as an expense—the current standard encourages but does not require that practice—have 

been put forward in the past, provoking significant controversy. The central concern driving such proposals was 

expressed as early as 1953 by the Committee on Accounting Procedures (the accounting standards board of that 

era):

To the extent that such options and rights [that is, 

options to purchase or rights to subscribe for 

shares of a corporation’s capital stock] involve a 

measurable amount of compensation, this cost of 

services received should be accounted for as such. 

The amount of compensation involved may be 

substantial and omission of such costs from the 

corporation’s accounting may result in overstatement of net income to a significant degree.1

The issue of requiring firms to recognize the fair value of 

employee stock options was raised most recently in 

March 2003 when the Financial Accounting Standards 

Board (FASB)—the independent private-sector board 

that currently sets U.S. financial accounting standards— 

announced that it planned to reconsider the current standard for equity-based compensation. This Congressional 

Budget Office (CBO) paper describes the issues that surround the debate about changing that standard, analyzing 

the current accounting requirement, the arguments advanced for and against requiring fair value recognition, 

and how such a change might affect the economy. The report also compares the methods now being used to value 

employee stock options, presenting a detailed example to 

illustrate the general effects of those methods.

The Key Issue: Intrinsic Versus

Fair Value 

In 1993, FASB recommended a change in the accounting 

treatment of employee stock options. It proposed that 

firms recognize the fair value of the options (measured 

when the options are granted) as an expense on their income statements over the period in which employees perform the services for which the options serve as compensation. (That period usually corresponds to the vesting 

period—the waiting period most companies require before the option holder may exercise the option.) However, FASB’s proposal encountered severe opposition, 

mostly from the managers of firms granting such options. 

Those managers preferred to continue to use the accounting treatment permitted under what was then the current 

standard—that is, to recognize the intrinsic (or immediate-exercise) value of employee stock options rather than 

the options’ fair value.2

 Their preference derived at least 

in part from the fact that at the time options are granted, 

the intrinsic value is almost always less than the fair value 

and thus a smaller amount is subtracted from firms’

earnings.

1. Committee on Accounting Procedures, Compensation Involved in 

Stock Option and Stock Purchase Plans, Accounting Research Bulletin No. 43 (1953), Chapter 13B.

2. That treatment was established in 1972 by FASB’s predecessor, the 

Accounting Principles Board, in its Opinion No. 25, Accounting 

for Stock Issued to Employees (referred to hereafter as Opinion 25).
2 ACCOUNTING FOR EMPLOYEE STOCK OPTIONS

The intrinsic value of an employee stock option is the extent to which an option’s strike price—the specified price 

at which the underlying stock may be purchased—is below the stock’s current market price. For example, an option to buy one share of stock at a strike price of $30 per 

share on a stock whose current market price is $35 has an 

intrinsic value of $5. Employee stock options may be 

structured so that their intrinsic value is zero—in the previous example, by setting the option’s strike price at $35 

or more.

The opposition engendered by FASB’s proposed change 

strengthened until intervention by the Congress appeared 

likely, so the accounting board amended its proposal to 

encourage—but not require—recognition of the fair 

value of employee stock options.3 However, FASB did require that firms electing to use the intrinsic value method 

disclose the effects of fair value recognition on their income.

The Current Accounting Standard

The current standard, which is spelled out in FASB Statement No. 123 (FAS 123), effectively allows companies to 

choose between two methods of valuing compensatory 

stock options:4

 they can recognize as an expense either 

the options’ fair value or their intrinsic value. If they elect 

to use the intrinsic value method, as most do, they must 

disclose the estimated fair value in the notes to their financial statements.5

 As mentioned earlier, FAS 123 encourages use of the fair value method—which recognizes 

Box 1.

The Accounting Framework

There are two basic accounting statements, the balance sheet and the income statement. Each provides 

information on a firm’s financial condition to investors and others outside the firm (creditors, for example).

The balance sheet is a summary of the firm’s net 

worth at a point in time. It shows what the firm 

owns (assets) and how the firm is financed (liabilities 

and shareholders’ equity). The accounting identity of 

the balance sheet is that assets equal liabilities plus 

shareholders’ equity (what shareholders would have 

after the firm had discharged all its obligations).

The income statement shows the firm’s performance 

for a specified period, such as a quarter or a year, 

measured by its earnings. For the income statement, 

net income equals revenue minus expenses. In general, revenue is the economic benefit generated by 

the firm’s activities, and expenses are the associated 

costs. Compensation and depreciation are examples 

of two types of expenses.

An accrual basis of accounting underlies most financial reporting. Under accrual accounting, revenue is 

recognized when it is earned and can be objectively 

measured. When possible, expenses are matched 

with revenue and are recognized in the same period. 

If an expense applies to multiple periods and cannot 

be definitively matched with revenue, it is apportioned in some manner over those periods. If the expense cannot be matched with revenue, it is recognized when it is incurred.

3. The Senate passed a resolution against the proposal. See amendment 1668 to the Consumer Reporting Reform Act, S. 783, 

103rd Congress, 1st sess. (1993).

4. Employee stock options may be compensatory or noncompensatory. Compensatory stock options are granted to employees in 

exchange for their services. Noncompensatory plans, such as 

employee stock ownership plans, are intended to serve other goals, 

such as promoting employees’ loyalty or raising capital without 

having to make a public offering of stock. FAS 123 applies only to 

compensatory stock options.

5. For example, when Cisco reported its quarterly earnings in 

November 2002, it disclosed that those earnings would have been 

60 percent lower under “fair value” accounting. (Specifically, its 

earnings of $618 million would have been reduced to 

$250 million if the $368 million in options it had granted had 

been recognized as an expense.) See Scott Thurm, “Cisco Discloses Expense Data on Stock Options,” Wall Street Journal, 

November 22, 2002, p. B6.
ACCOUNTING FOR EMPLOYEE STOCK OPTIONS 3

an option’s estimated market value on the date the option 

is granted—but does not require it.6 Firms estimate such 

values through the use of both analytic option-pricing 

methods and the options’ prevailing market prices. If the 

market price of a stock is greater than zero, the fair value 

of an employee stock option will also be greater than zero.

Companies that use the intrinsic value method almost always grant fixed stock options with a strike price at or 

above their stock’s prevailing market price. (If the strike 

price was set below the prevailing market price—so that 

the option had a positive intrinsic value, or was “in the 

money”—the company would be required to count that 

difference as an expense.) As noted earlier, an option with 

a strike price equal to or greater than the current market 

price of the underlying stock has an intrinsic value of 

zero.

The intrinsic value method understates the market value 

of employee stock options for at least two reasons. First, it 

assigns no value to the probability that the market price 

of the stock will rise above the strike price. Second, it 

does not account for the time value of the money that the 

option holder saves by being allowed to defer the purchase of the stock.7

 Yet an option has a positive fair value 

even if the strike price exceeds the market price of the 

stock when the option is granted because the time value 

of money and the chance that the stock’s market price 

will exceed the option’s strike price before expiration are 

always greater than zero. (Indeed, the longer the life of 

the option—the period during which it can be exercised—the greater the chance that the stock’s price will 

exceed the strike price.)

The majority of companies that grant employee stock options have fixed stock option plans and until recently 

have chosen to use the intrinsic value method—that is, to 

merely disclose the fair value of the options that they 

grant rather than to recognize that amount as an expense. 

Until 2002, only two major firms (Boeing and WinnDixie Stores) had elected to use the fair value method in 

accounting for employee stock options. Since July 2002, 

however, nearly 500 U.S. firms have announced that they 

will voluntarily adopt that valuation method.8

FASB’s Proposal

In March 2003, FASB announced plans to reconsider the 

current standard for equity-based compensation. Its 

stated objective was to cooperate with the International 

Accounting Standards Board (IASB) to establish a single 

international accounting standard for such compensation.9 On March 31, 2004, FASB released its proposal to 

require firms to recognize the fair value of employee stock 

options—eliminating the alternative of recognizing the 

intrinsic value and merely disclosing the fair value in a 

note.10 The prospect of that revision has prompted considerable controversy, with the managers of many firms 

that grant such options reiterating their opposition to the 

requirement. For many observers, the challenge of this issue is to understand the arguments being offered on both 

sides of the debate.

Why Firms Grant Stock Options

Firms grant employee stock options as compensation for 

any of a number of reasons: to minimize the firm’s compensation costs, to conserve cash, and to avoid the limits 

on the tax deductibility of cash compensation. Employee 

6. FAS 123 allows firms to account for employee stock options as 

prescribed by Opinion 25. Under the Opinion 25 standard, the 

measurement date for determining the compensation expense of 

employee stock options is the first date on which the number of 

shares that the employee is entitled to receive and the exercise 

price are known. For fixed stock options, those parameters are 

generally known at the time that the options are granted. (Fixed 

stock options, so called because the number of shares to which an 

employee is entitled is known at the time of the grant, are the 

most common form of stock compensation plan.) In contrast, the 

measurement date for determining the compensation expense of 

performance stock options (options for which vesting depends on 

both the employee’s continued service to an employer and the 

achievement of performance goals, such as exceeding a sales target) may be later than the date on which they are granted. That is 

because the terms of the award (the number of shares that may be 

purchased and the strike price) depend on events that occur after 

the options are awarded.

7. The time value of money is the idea that a dollar now is worth 

more than a dollar in the future, even after adjusting for inflation, 

because a dollar in hand today could earn interest, for example, 

until the time that the dollar in the future was received. 

8. See David Reilly, “Foreign Firms to Expense Options,” Wall Street 

Journal, February 19, 2004, p. A2.

9. In February 2004, the IASB issued a rule to require the expensing 

of employee stock options. See Reilly, “Foreign Firms to Expense 

Options.”

10. Financial Accounting Standards Board, Proposed Statement of 

Financial Accounting Standards: Share-Based Payment (No. 1102-

100, an amendment of FASB Statements No. 123 and 95),

March 31, 2004, available at www.fasb.org/draft/ed_intropg_

share-based_payment.shtml.
4 ACCOUNTING FOR EMPLOYEE STOCK OPTIONS

stock option grants may also be desirable from the shareholders’ standpoint because the options help align managers’ incentives with shareholders’ interests. Some critics 

argue, however, that the current accounting standard may 

contribute to an excessive use of such options—which 

may actually work against that alignment objective.

A firm creates value for its owners through its economic 

activity. In the case of a corporate firm, shareholders are 

the owners, contributing capital in return for owning 

shares of the business. Shareholders possess a so-called

residual-ownership claim—that is, they bear the ultimate 

risk of loss and receive the benefits of profitability after all 

prior claims have been satisfied. Shareholders’ risk of loss 

is limited to their investment; their gain is limited only by 

a firm’s ability to create value.

Shareholders have what is known as a principal-agent relationship with the management of a firm. Managers are 

essentially agents of the owners, or principals. Left to 

their own devices, managers may act in their own best interest, which may not be the same as that of the shareholders—a phenomenon known as the agency problem. 

Shareholders can encourage managers to take actions that 

are consistent with their own interests by devising appropriate managerial incentives and then monitoring managers’ performance. 

Compensating managers with stock or with employee 

stock options may give those executives a stronger incentive to take actions that, for example, increase the price of 

the firm’s stock. However, compensating managers with 

employee stock options does not completely solve the 

agency problem.

Another reason that firms grant employee stock options is 

to minimize their compensation expenses. Market forces 

determine the total compensation of workers. Employee 

stock options are often part of a package that includes 

wages, benefits, and working conditions. Firms try to 

structure such packages to appeal to workers and spur 

their efforts at the lowest cost to the firm.

For highly compensated employees, granting stock options can be less expensive for firms than other forms of 

compensation, such as cash salaries or outright grants of 

stock. For tax purposes, compensation (as well as other 

expenses) is normally deducted from a firm’s gross income to arrive at its taxable income. But tax legislation 

enacted in 1993 disallows the deductibility of compensation paid to executives that exceeds $1 million—unless 

that compensation is “performance based.” Fixed stock 

options are deemed performance-based compensation for 

tax purposes. Employee stock options therefore may reduce taxable income—and taxes—when cash compensation does not. 

The current accounting treatment of employee stock options provides an additional incentive for firms to grant 

options as part of employees’ compensation because it allows firms to recognize the expense of some employee 

stock options at less than their market value—in most 

cases, at a value of zero. That treatment helps accommodate the seemingly conflicting incentives firms face in reporting their income for financial-accounting and for tax 

purposes. For financial-reporting purposes, firms prefer 

to maximize their reported income, but for tax-reporting 

purposes, they are interested in minimizing it. Current 

standards effectively allow firms to do both to some extent: they may record a compensation expense of zero for 

employee stock option grants in their financial reports, 

but they may also deduct the actual exercise value of 

those options as compensation expense on their tax returns.

Potential Economic Effects of

Fair Value Recognition

Recognizing the fair value of the employee stock options 

that firms grant would enable analysts and investors to 

more easily assess firms’ compensation expenses and how 

those expenses affected firms’ profits. That improved 

transparency would also aid corporate committees that 

approve managers’ compensation packages. But some opponents of requiring firms to recognize the fair value of 

employee stock options contend that such a requirement 

might negatively affect the U.S. economy by lowering the 

price of firms’ stock and hindering firms’ access to capital.

Whether or not a requirement to recognize the fair value 

of employee stock options would reduce stock prices is an 

unsettled question. On the one hand, recognizing the options’ fair value as an expense might drive down firms’ 

stock prices if the current method of merely disclosing 

the fair value prevents investors from understanding the 

firms’ actual profitability. Lower stock prices in turn 

might hurt the ability of those firms to raise capital, invest, and grow. (Lower stock prices could also lessen 

firms’ propensity to grant employee stock options.) On 

the other hand, if equity markets are efficient at process-
ACCOUNTING FOR EMPLOYEE STOCK OPTIONS 5

ing the disclosed information about the fair value of options, which is not recognized in income statements, then 

the options’ effect is already incorporated in stock prices, 

and a change in accounting treatment will have no further impact.

Experience to date suggests that the accounting change 

proposed by FASB will not necessarily have an adverse effect on stock prices of all firms that grant compensatory 

options. Studies of companies that have announced 

within the past three years that they will voluntarily 

switch to the fair value method have found no significant 

change in stock prices as a result of that announcement.11

Of course, those firms that voluntarily changed to the fair 

value method might be those that anticipated a favorable 

outcome or no effect from doing so. Nevertheless, the results indicate that firms’ stock prices are unlikely to experience a uniform adverse impact from the proposed 

change.

Experience has also shown that it is unnecessary for firms 

to overstate their net income in order to raise capital. Investors that perceive opportunities for growth in a firm’s 

revenue and earnings have shown themselves willing to 

invest despite a less-than-outstanding current income 

statement.12 Furthermore, many companies in the startup phase of their operations turn to venture capitalists 

and private equity firms for fund-raising. Those organizations are made up of skilled investors who will be able to 

look past the stock options’ expense to see the firm’s potential.

If stock prices and access to capital are little affected, recognizing the fair value of employee stock options rather 

than merely disclosing it is unlikely to hurt the overall 

economy. In fact, if recognition of that expense better informs investors about firms’ profitability than disclosure 

does, capital will be allocated more efficiently, and the 

economy will be more productive. To the extent that 

grants of employee stock options are motivated by the 

discrepancy between the economic and accounting values 

of those options, recognizing their fair value may reduce 

the number of options that are granted, but it should not 

create an unwarranted bias against their use. 

Valuing and Recognizing

Employee Stock Options

Because the value of an option changes with time and as a 

result of other factors, including fluctuations in the price 

of the underlying stock, a point must be chosen at which 

to measure that value. Under the fair value method of the 

current accounting standard, the value of employee stock 

options is measured when they are granted. However, the 

options’ value might also be measured at the end of the 

vesting period or when they are exercised, and arguments 

for measuring value at those points have been made. An 

important additional question is whether the options’ 

value can be reliably estimated, whatever point is eventually chosen.

An option’s value at the end of the exercise period is almost always different from its value when it was granted. 

In general, and all other things being equal, the longer 

the exercise period of an option, the higher the option’s 

value will be—because of the greater chance that the market price of the stock will rise above the strike price. If the 

market price of the stock fails to exceed the option’s strike 

price, the option holder will not exercise the option.

The Difficulty of Measuring the Value of

Employee Stock Options

Employee stock options are difficult to value precisely. 

Mathematical models have been developed to value exchange-traded options (including call options), but in order to use them for employee stock options, the models 

must be adjusted to account for the differences between 

the two kinds of options. (See Box 2, which describes 

how employee stock options differ from call options.) For 

example, exchange-traded options are transferable without restriction, whereas employee stock options have a 

significant vesting period and even then usually cannot be 

sold (only exercised). Employee stock options also have a 

longer exercise period than most exchange-traded options 

have. As a result, the actual value of employee stock options is likely to be different from the value predicted by 

models developed for exchange-traded options.

11. See Ashish Garg and William Wilson, “Expensing of Options: 

What Do the Markets Say?” CrossCurrents (Fall 2003), pp. 2-9; 

and “Option Expensing Announcement Has No Impact on Share 

Price, Towers Perrin Event Study Affirms,” available at www.

towersperrin.com/hrservices/global/default.htm.

12. Throughout the 1990s, for example, many firms with little or no 

revenue successfully sold shares. For a discussion, see Robert N. 

McCauley, Judith S. Ruud, and Frank Jacono, “Cheap Equity 

Capital for Young Firms,” in Dodging Bullets: Changing U.S. Corporate Capital Structure in the 1980s and 1990s (Cambridge, 

Mass.: MIT Press, 1999), pp. 247-264.
6 ACCOUNTING FOR EMPLOYEE STOCK OPTIONS

Yet despite those difficulties, many market participants 

regard current valuation methods as reliable. Firms are already using current methods to calculate the fair value of 

all employee stock options as required for disclosure in 

the notes of their audited financial reports. Moreover,

option-pricing models are used by traders and investors 

whose money is at risk to value options that are much 

more complex than employee stock options. 

Another indication that the value of employee stock options may be estimated reliably is the fact that in some instances, firms that grant such options and the employees 

who receive them can enter into other financial transactions designed to protect against losses. Such transactions, 

known as hedging, are financial techniques that are structured so that the gain or loss on one holding is offset by 

the gain or loss on another. (For example, if an investor 

wanted to completely hedge the payoff of writing (selling) a call option, he or she could simultaneously buy a 

call option with the same terms.)

13

Box 2.

How Employee Stock Options Differ from Call Options

Employee stock options are sometimes described as 

call options because their fundamental function is 

the same. Both types of securities give the holder the 

right to buy a specified number of shares of a firm’s 

stock at a specified price (the strike price, or exercise 

price) until a given date (the expiration date). However, employee stock options differ from call options 

in several respects. An important distinction is that 

employee stock options, unlike call options, are corporate securities (that is, issued by corporations).

In general, the two parties to an option contract are 

the creator or issuer of the option, also known as the 

seller or writer, and the purchaser of the option, also 

known as the buyer or holder. With employee stock 

options, the corporation is the writer and the employee recipient of the employee stock option is the 

holder. At the inception of the option contract, the 

writer receives the price paid for the option, referred 

to as the premium. (In the case of employee stock 

options, the premium is the forgone cash wages.) 

Call options and employee stock options both confer 

on the holder the right to gain from increases in the 

stock price, with the risk of loss limited to the price 

paid. A rise in the price of the underlying stock results in gains for the holder, equal to the excess of the 

market price over the exercise price. Gains to the 

holder are losses to the writer.

Unlike call options, employee stock options usually 

have a vesting period—a specified waiting period before they may be exercised—which typically ranges 

from two to four years. In addition, employee stock 

options are usually nontransferable, meaning that 

the employees may not sell them to others. 

Another difference is that the exercise of employee 

stock options affects the corporation’s holdings of 

cash and its number of shares outstanding. Because 

employee stock options are written by corporations 

rather than by individuals, the holder pays the strike 

price to the corporation when he or she exercises the 

options. As a result, the firm’s cash increases, and the 

firm issues new shares. In contrast, the exercise of ordinary call options results in the transfer of existing 

shares from one shareholder to the option holder and 

affects neither the value of the firm’s assets nor the 

number of shares outstanding.

13. However, there are also ways to hedge a financial instrument without buying or selling the same instrument, and there are ways to 

partially hedge, so that the risk of loss or gain is lessened but not 

eliminated. For an explanation of how firms hedge their exposure, 

see Gene Amromin and Nellie Liang, “Hedging Employee Stock 

Options, Corporate Taxes, and Debt,” National Tax Journal, vol. 

56, no. 3 (September 2003), pp. 513-533. For a discussion of 

ways that recipients may hedge, see, for example, J. Carr Bettis, 

John M. Bizjak, and Michael L. Lemmon, “Managerial Ownership, Incentive Contracting, and the Use of Zero-Cost Collars and 

Equity Swaps by Corporate Insiders,” Journal of Financial and 

Quantitative Analysis, vol. 36, no. 3 (September 2001), pp. 345-

370.
ACCOUNTING FOR EMPLOYEE STOCK OPTIONS 7

When Should the Value of Employee

Stock Options Be Measured?

Because the estimated fair value of employee stock options changes continually from the granting date until the 

exercise date, when options are valued determines the 

amount that firms recognize on their income statements. 

The value of firm-written employee stock options may be 

measured at three different points: when they are granted, 

when the vesting period ends, or when they are exercised.

Valuing Options When They Are Granted. Most analysis 

supports valuing employee stock options when they are 

granted because their value at that point most closely corresponds to the cost to the firm of the compensation that 

they represent. According to that rationale, such options 

are given in lieu of cash compensation, and their value is 

approximated by their market value—that is, the firm incurs a cost when it grants employee stock options, a cost 

equal to the value for which the options could be sold. In 

theory, employees in competitive labor markets who receive options are subject to an equivalent reduction (in 

the amount of the options’ value) in their cash compensation.14

Another factor that determines the compensation expense 

of the employee stock options that a firm grants is the 

number of options that are expected to vest. (If employees do not remain with the firm long enough to satisfy 

the options’ vesting period, they forfeit the options 

granted to them.) Firms are permitted to estimate the 

value of the options that they expect will not be exercised 

and to factor in that amount when they calculate the 

compensation expense of the options that must be recognized. Under the current accounting standard—regardless of whether the firm is using the fair value or intrinsic 

value method—firms do not recognize any compensation 

expense for options that they expect will be forfeited by 

employees who fail to satisfy vesting requirements.

The fair value method of the current accounting standard 

requires firms to measure the value of employee stock options (that are expected to vest) when the options are 

granted. According to FASB, that value constitutes the 

entire amount of the compensation given to employees in 

the form of stock options. Any subsequent gain or loss in 

the options’ value does not affect the value of the firm 

granting them but is instead a direct transfer of wealth 

from current shareholders to option holders (see the later 

discussion).

Valuing Options When They Vest. Because employees cannot exercise their options until the end of the vesting period, some analysts contend that the options’ value 

should not be measured until then. An advantage of waiting is that by that time, the number of vested options is 

known and does not have to be estimated (as it does if the 

options’ value is measured when the options are granted). 

But the firm, not the employee, is the relevant reporting 

entity whose finances are being disclosed under the various accounting standards. As such, the appropriate issues 

are the cost of the options to the firm and when the firm 

incurs that cost. The firm obligates itself as a writer of the 

options on the date that it grants them—options are 

binding contracts between the firm and the employee and 

must be fulfilled. Thus, the options’ value at vesting is irrelevant to the options’ cost to the firm; the firm already 

incurred that cost when the options were granted.

Valuing Options When They Are Exercised. Because the 

value of employee stock options is realized only when the 

options are exercised, some observers argue that that is 

the appropriate time to measure their value. Indeed, for 

tax purposes, the gain that employees realize when they 

exercise most compensatory stock options is the value 

that the firm may deduct as compensation expense from 

its gross income in determining its taxable income; it is 

also the measure of the compensation received by the individuals who exercise the options. But for financialaccounting purposes, the relevant issues are the options’ 

cost to the firm and when the firm incurs that cost—that 

is, the value of the options when they are granted.

When employees exercise their stock options, they buy 

shares of stock from the firm for less than the stock’s market value. However, changes in the value of employee 

stock options between the time they are granted and the 

time they are exercised do not represent an additional 

cost to the firm (and so are not recorded on the firm’s income statement). Rather, they simply transfer wealth between existing shareholders and stock option holders. 

That transfer of wealth represents a gain to the employees 

who are exercising the stock options—and a loss to existing shareholders—but it has no effect on the value of the 

firm. When employees exercise their stock options, the 

14. If employee stock options were given in excess of competitive market compensation, that would imply that the boards of directors 

of firms were not fulfilling their fiduciary duties to shareholders. 
8 ACCOUNTING FOR EMPLOYEE STOCK OPTIONS

firm experiences no outflow of resources. To fulfill the 

employee stock option contract that it wrote, the firm is 

required only to issue additional equity claims (shares of 

stock), which it can do at any time at no cost to itself—

although such an issuance does reduce the value of the 

claims of existing equityholders.15 The value of the firm 

is affected only when the options are granted—that is, 

when the firm incurred the cost of granting the options 

to employees as part of their compensation instead of selling the shares to investors.

When Should the Expense of Employee Stock 

Options Be Recognized?

Compensation is an operating expense, a cost of doing 

business. For the sake of accuracy, it should be treated like 

other operating expenses—matched with revenue and 

recognized in the same period. Thus, under the current 

accounting standard, the expense of employee stock options is measured when the options are granted and is recognized over the time (the vesting period) during which 

employees render services to the firm in exchange for the 

compensation that the options represent. The justification for recognizing the expense over the vesting period is 

that the employee earns the compensation (the stock options) only by continuing to work for the firm during 

that time.

Some observers, however, question whether employee 

stock options are indeed compensation. They claim that 

such options are “capital” income (income earned from 

investment ownership of a security) rather than labor 

compensation. But that argument fails to distinguish two 

separate events: the granting of an employee stock option, 

which conveys a specific amount of compensation, and 

subsequent gains or losses from changes in the option’s 

value. The initial grant is compensation; subsequent 

gains and losses may be considered investment income 

for the option’s holder. 

In contrast to operating expenses, financing transactions, 

such as sales of stock, usually do not affect a firm’s income 

statement. Rather, they affect its balance sheet by changing the firm’s assets and the claims on those assets (in the 

form of liabilities and equity). Financing transactions do 

not directly affect the amount of income earned by the 

firm and thus do not augment the investment of existing 

shareholders. When stock is issued, for example, cash assets and shareholders’ equity both increase (along with 

the number of shares outstanding), but no income results 

from that transaction.

The use of employee stock options effectively involves 

two types of transactions: the payment of compensation 

in the form of employee stock options (reflected on the 

income statement) and, when the options are exercised, a 

financing transaction (reflected on the balance sheet). 

That “hybrid” transaction requires recognizing the value 

of the options when they are granted as a cost on the income statement—but not any subsequent gains and 

losses in that value. As the following example shows, that 

treatment is consistent with the fair value method of accounting.

Comparing Accounting Alternatives:

An Example

CBO prepared an example to show how a firm can account for some of the different forms of compensation 

that it grants to its employees. In this example, the firm 

has assets of $2,000, no debt, shareholders’ equity of 

$2,000, annual revenue of $1,000, and fixed marketdetermined compensation expenses of $1,000 annually 

(the firm grants no dividends and pays no taxes). Before 

presenting the accounting for grants of employee stock 

options as compensation, the example shows the accounting for grants of stock and purchased call options in lieu 

of cash compensation. 

Granting Cash, Stock, and Purchased Call Options 

as Compensation

The firm’s financial statements will differ depending on 

whether it pays all compensation in cash or pays $200 

worth of stock or purchased call options in lieu of cash 

compensation (see Table 1). Although net income is zero 

in all three cases (because total expenses are equal to revenues), granting stock for part of employees’ pay will leave 

the firm with $200 more in cash assets.16 Granting stock 

15. Share price dilution results when the number of ownership claims 

on the firm increase, but the firm’s market value does not rise proportionately. See the example in the last section for further discussion. 

16. Under current accounting rules, if the firm grants stock in lieu of 

cash compensation, the value of that stock is recognized on the 

firm’s income statement as compensation expense.
ACCOUNTING FOR EMPLOYEE STOCK OPTIONS 9

Table 1.

Comparison of Accounting Treatments for Selected Forms of Compensation:

Cash, Stock, and Purchased Call Options

(Dollars)

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

The year referred to in this table is the one in which the stock options are granted.

a. In this example, the firm has no liabilities. For a review of income statements and balance sheets, see Box 1.

causes owners’ equity to be $200 higher, because employees have in effect contributed $200 to owners’ equity by 

accepting stock instead of cash compensation. (It is as if 

employees were paid $1,000 in cash, and then the employees paid $200 of that cash to the firm in exchange for 

stock.) By granting compensation in the form of stock, 

the firm has more total owners’ equity, but it also has 

more shares outstanding. Existing shareholders will suffer 

no loss in the value of their shares from the increase in 

shares if employees paid the fair market value for the new 

shares in forgone cash compensation. 

If the firm pays a portion of employees’ compensation 

with call options purchased from a third party, its financial statements will be similar to those under the cashcompensation scenario. (In this case, it is as if employees 

were paid $1,000 in cash and then the employees paid 

$200 of that cash to the third party in exchange for the 

call options.) The firm recognizes as an expense the fair 

value of the options it purchased. Because a third party 

wrote the options, the firm’s existing shareholders will not 

face the prospect of any share price dilution (reduction in 

wealth) if the options are exercised. In contrast, with employee stock options that the firm writes itself, the fair 

value may not be recognized as an expense on the 

Firm Pays

Compensation 

Entirely in Cash

Firm Grants Stock in 

Lieu of $200 of Cash 

Compensation 

Firm Grants 

Purchased Call

Options in Lieu of 

$200 of Cash

Compensation

Income Statement

Revenues 1,000 1,000 1,000

Expenses

Cash compensation -1,000 -800 -800

Stock compensation n.a. -200 n.a.

Purchased call option compensation n.a. n.a. -200

Net Income 0 0 0

Balance Sheeta

Assets

Assets at the beginning of the year 2,000 2,000 2,000

Plus cash conserved by compensating

with stock n.a. 200 n.a.

Assets at the end of the year 2,000 2,200 2,000

Equity

Owners’ equity at the beginning of the year 2,000 2,000 2,000

Additional owners’ equity 0 200 0

Owners’ equity at the end of the year 2,000 2,200 2,000
10 ACCOUNTING FOR EMPLOYEE STOCK OPTIONS

Table 2.

Comparison of Accounting Treatments for Employee Stock Options

(Dollars)

Source: Congressional Budget Office.

Notes: The year referred to in this table is the one in which the stock options are granted.

In this example, the fair value of the options is recognized (subtracted from income) when the options are granted. That accounting 

method is identical to the treatment of the grant of $200 in stock compensation noted in Table 1.

Under the intrinsic value method of accounting, the exercise value of the options is also recognized when they are granted. (In this 

case, that value is zero.) However, the current accounting standard is slightly more complicated and hence difficult to include in this 

table: valuation occurs at grant and recognition occurs over the vesting period. (In this example, the options vest immediately.)

An option is “at the money” if the share price of the underlying stock is equal to the strike price of the option.

a. In this example, the firm has no liabilities. For a review of income statements and balance sheets, see Box 1.

firm’s income statement, and existing shareholders will 

experience share price dilution if the options are exercised. 

Granting Employee Stock Options in Lieu of

Equivalent Cash Compensation

If the firm grants employee stock options as compensation, the accounting treatment is more complex. In this 

scenario, the firm grants at-the-money options with a fair 

value of $200 in lieu of that amount of cash compensation (by assumption, the options vest immediately). Issuing employee stock options instead of cash permits the 

firm to retain cash equal to the value of the options and 

gives employees a contingent claim on the firm. By substituting employee stock options for $200 in cash compensation, the firm retains $200 more in cash. Whether 

the firm reports net income of zero or $200, however, depends on which method it uses to value the options (see 

Table 2).

With the fair value method, the firm recognizes as an expense the fair value of the options at grant ($200), so its 

net income is unchanged relative to paying all compensation in cash. (That accounting treatment is identical to 

Firm Grants $200 Worth of At-the-Money 

Options in Lieu of Cash Compensation

Fair Value

Method

Intrinsic Value

Method

Income Statement

Revenues 1,000 1,000

Expenses 

Cash compensation -800 -800

Option compensation -200 0

Net Income 0 200

Balance Sheeta

Assets

Assets at the beginning of the year 2,000 2,000

Plus cash conserved by compensating with options 200 200

Assets at the end of the year 2,200 2,200

Equity

Owners’ equity at the beginning of the year 2,000 2,000

Addition to owners’ equity from net income 0 200

Option holders’ equity 200 0

Owners’ and option holders’ equity at the end of the year 2,200 2,200
ACCOUNTING FOR EMPLOYEE STOCK OPTIONS 11

that of the scenario in which the firm grants $200 in 

stock compensation.) The intrinsic value method recognizes the immediate-exercise value of the options (zero), 

rather than the fair value ($200), and thus reports net income of $200. Under both methods of valuation, cash assets are higher by $200. 

If the employee stock options that the firm has granted 

subsequently change in value, that change will have no effect on the firm’s income statement or balance sheet under either accounting method. (Similarly, a change in the 

market value of a stock will have no effect on a firm’s financial accounting after the stock is granted as compensation.) If the options granted in this example increase in 

value by, say, $100, the firm’s reported net income will 

still be zero.

Letting Options Expire or Exercising Them

At the end of the life of an option (its expiration), its 

holder will either exercise it at a gain or allow it to expire 

unexercised. At that point, the firm’s income is unaffected 

under both fair value and intrinsic value accounting, 

whether the option is exercised or expires unexercised. 

Options Expire Unexercised. If the employee stock options that were worth $200 when the firm granted them 

subsequently fall in value and are not in-the-money, then 

the holders will choose to let the options expire unexercised. The final balance sheet and income statement 

numbers in that scenario are identical under both the fair 

value and intrinsic value methods (see the first two columns of Table 3). Although the options have decreased in 

value, that decline will have no effect on the firm’s income under either accounting method. 

Options Are Exercised. If those options that were worth 

$200 when the firm granted them subsequently increase 

in value and are in the money, then the holders will 

choose to exercise them by paying the firm the strike 

price in exchange for the stock. Suppose that the employee stock options granted in this example were for 100 

shares of stock, with a strike price of $10, and that the 

market price of the stock has risen to $13. In that case, 

option holders pay the firm $1,000 in cash (100 shares of 

stock times the strike price of $10 per share), which increases owners’ equity by the same amount (see the last 

two columns of Table 3). 

While the income statement and the ending value of the 

balance sheet are the same under both accounting methods when employee stock options are exercised, the balance sheet entries differ. Under the fair value method, the 

option holders’ equity is transferred to owners’ equity 

upon the exercise of the employee stock options, because 

exercising the options results in the option holders’ receiving ownership shares. Under the intrinsic value 

method, there is no option holders’ equity to transfer.

What the financial statements do not show, however, is 

the economic effect of the exercise of stock options on existing shareholders. When firm-written stock options are 

exercised, wealth is transferred from existing shareholders 

to those exercising the options. Such share price dilution 

is not a cost to the firm per se, but it is certainly relevant 

to existing shareholders, as shown below.17

If immediately before the exercise of the employee stock 

options, the firm had 500 shares of its stock outstanding, 

trading at $13 per share, then the market value of the 

firm was $6,500 ($13 times 500). Upon the exercise of 

the employee stock options for 100 shares, the option 

holders pay a total of $1,000 to the firm. That transaction simultaneously increases the market value of the firm 

to $7,500 and boosts the number of shares outstanding 

to 600. Thus, immediately after the exercise of the employee stock options, the market price of a share of the 

firm’s stock falls to $12.50 ($7,500 divided by 600). 

Therefore, the exercise of the employee stock options 

caused existing shareholders to transfer 50 cents per share 

of the value of their shares to those exercising the options.

The Bottom Line: Reporting Differences

Between the Two Accounting Methods 

The fair value method and intrinsic value method of accounting for employee stock options result in different reported net income for the same firm. The firm in this example has no annual net income from operations. But by 

using the intrinsic value method of accounting, the firm 

reports $200 in net income in the year in which the employee stock options were granted, an overstatement 

equal to the value of the options on the granting date. No 

subsequent transaction reverses or offsets that overstatement.

17. If the firm had purchased call options from another entity to grant 

to employees rather than writing them itself, the exercise of those 

purchased call options would not result in share price dilution for 

existing shareholders.
12 ACCOUNTING FOR EMPLOYEE STOCK OPTIONS

Table 3.

Comparison of Accounting Treatments for Employee Stock Options

at Expiration

(Dollars)

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

The year referred to in this table is the year in which the options expire.

a. In this example, the firm has no liabilities. For a review of income statements and balance sheets, see Box 1.

Options Are

Unexercised

100 Options Are Exercised

at a Strike Price of $10

Fair Value

Method

Intrinsic Value 

Method

Fair Value

Method

Intrinsic Value 

Method

Income Statement

Revenues 1,000 1,000 1,000 1,000

Expenses—Cash Compensation -1,000 -1,000 -1,000 -1,000

Net Income 0 0 0 0

Balance Sheeta

Assets 

Assets at the beginning of the year 2,200 2,200 2,200 2,200

Cash received (paid) from option exercise n.a. n.a. 1,000 1,000

Assets at the end of the year 2,200 2,200 3,200 3,200

Equity

Option holders’ equity at the beginning of 

the year

200 0 200 0

Transfer to owners’ equity -200 0 -200 0

Option holders’ equity at the end of the year 0 0 0 0

Owners’ equity at the beginning of the year 2,000 2,200 2,000 2,200

Transfer from option holders’ equity 200 0 200 0

Change in owners’ equity from option 

exercise

 n.a. n.a. 1,000 1,000

Owners’ equity at the end of the year 2,200 2,200 3,200 3,200