Stock Options

Stock Options Definition (in the Accounting Vocabulary)

The New York State Society of Certified Public Accountants offers the following definition of Stock Options in a way that is easy for anybody to understand: Right to purchase or sell a specified number of shares of stock at specified prices and times.

1) Terminology

a) Grant date – The date at which an employer and an employee reach a mutual understanding of the key terms and conditions of a share-based payment award. The employer becomes contingently obligated on the grant date to issue equity instruments or transfer assets to an employee who renders the requisite service. Awards made under an arrangement that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality (or perfunctory), for example, if management and the members of the board of directors control enough votes to approve the arrangement. Similarly, individual awards that are subject to approval by the board of directors, management, or both are not deemed to be granted until all such approvals are obtained. The grant date for an award of equity instruments is the date that an employee begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer’s equity shares.

b) Measurement Date – The date at which the equity share price and other pertinent factors, such as expectedvolatility, that enter into measurement of the total recognized amount of compensation cost for an award of share-based payment are fixed

c) Fair value – The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.

d) In the Money option – Option granted with an exercise price below the market price on the grant date

e) Out of the Money option – Option granted with an exercise price above the market price.

f) Backdating

I) Exercise price is based on a lower share price prior to the option grant date. The practice of marking a document with a date that precedes the actual date.

II) Example – Option is approved by the board permits the stock to be priced based upon the lowest price in the past 30 days- permits options to be in the money when issued. Options are suppose to be issued at option price that is neutral at time of issuance.

iii) May not be illegal if

(1) Clearly communicated to shareholders

(2) No documents forged

(3) Reflected in earnings of the company

(a) If under A PB 25 –the granting of in the money options resulted in recognition of compensation expense in earnings. If options were neutral or out of the money then. no compensation would be recognized

(b) If under 123R expense is based upon fair value at grant date. and compensation is recognized it the earningsstatement

g) Spring loading – Timing of option grants to take place before good news or after bad news is released

i) Concerns about insider trading

h) Forward loading – Term used for setting the option grant date to occur after predicted fall in stock price or before predicted stock price increase

i) Terms might involve option to be issued with price to be determined based upon the lowest price as of the issue date or for the next 30 days after the issuance. Grant date does not occur until the conclusion of the 30 day periodwhen the price is known. To determine the price the company needs to look back at the stock price for the last 30 days to determine what the exercise price should be. This is another version of backdating.

I) Discounted options – options that have an exercise price that is less than fair value on the date of grant.

2) Accounting and Tax Ramifications

a) Accounting ramifications

I) Restatement

II) Unable to file on timely basis while go back and determine what periods are effected

III) Calls into questions company’s internal controls and governance

IV) Will be unable to file shelf registration

V) May be delisted from exchange

b) SEC reporting implications

I) Potentially inaccurate reporting of executive compensation in proxy statements and annual reports

II) Potential violation of securities and Law for executive oficiers and directors with Section 16 (a) of the Securities and exchange Act of 1934. required to report on form 4

III) Potential false or misleading disclosures about the company’s stock option plan in periodic reports filed with the SEC – Failure to disclose the practice of backdating may violate securities and laws against false or misleading disclosures

IV) Potential false Section 302 certifications – Principal and financial executives are required to sign certifications in quarterly and annual reports certifying that among other things that the report filed with the SEC does not include any false statements of amaterial fact or state material facts necessary in order to make the disclosures not misleading.

c) Tax Ramifications

I) Exercise price effects capital gains of the individual and effects compensation expense used by corporation for calculating company’s compensation expense for tax purposes,

II) Tax ramifications – company

(1) Discounted options that become vested on or after January 1, 2005 are subject to non qualifying deferred compensation rules –

Holder is required to select a fixed exercise date no later than December 31, 2006 or be subject to immediate taxation on vesting , a 20 percent penalty and an interest assessment.

(2) May cause the loss of tax deductions under Section 162 (m), the deduction that public companies take for compensation to chief executive officer and next four highest compensated officers is limited to $1 million each. The deduction for stock options in not usually limited. However, discounted options do not qualify as performance based compensation and therefore the deduction that the company would get may be partially or completely lost. In addition discounted stock options do not qualify for Incentive Stock option (ISO) treatment. (ISO there is no payroll tax or withholding requirements for ISO’s) – If company mistakenly treats backdated stock as an ISO the company my fail to meet payroll tax and income tax withholding requirements.

d) New Rules SEC

I) Effective for years after December 15, 2006

II) New Disclosures mandated

(1) Fairvalue of options on grant date

(2) Value of grant per 123R

(3) Closing price market price on the date of grant if it is greather than the excericise price of the award

(4) The date the compensation committee or board took action to grant an award if theat date is different than the actual grant date.

(5) Also if the exercise price of an option grant differs from the closing market price per share on the grant date companies must include a description of the method for determining the exercise price.