Code Internal Revenue Service Joint Comm. After FIN 44 By Stephen G. Driggers, Esq. This means that any increase in the value of the underlying stock above the exercise price from the date of grant until the date the option either is exercised or terminates must be recorded as a compensation expense. Background Stock options are issued to attract and retain employees and to align their interests with those of other shareholders.
Stock options are attractive to issuers because they receive favorable accounting treatment.
When options are granted to employees with exercise prices equal to the market value of the underlying stock on the date of grant, there is no compensation expense to the issuer. At the same time, employees view the potential returns from their options as a major reason for joining and remaining with a growth company. On the other hand, underwater options quickly lose their luster and cease to motivate and retain the optionees who hold them. Adding insult to injury, in a company where options are granted to new hires while the stock price is falling, long-term employees find themselves holding options with higher exercise prices than those of the new hires. This result is prohibitive for most companies.