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employee stock options applications

Application:
In a conventional employee stock-options plan, key employees are granted the right to buy a fixed number of shares for a predetermined period. The number of shares granted depends on the employee's level of responsibility. Usually, the number of shares granted under an employee stock-option plan is commensurate with total compensation. According to current tax law, the exercise period for employee stock options cannot exceed 10 years, but may be less. Because stock prices usually rise from 10 to 12 percent per year, on average, from the employee's perspective, the longer the exercise period, the better.
An employee can exercise the right to buy stock covered by a stock-option plan once the vesting period has been completed. The vesting period is an employment time frame after which granted options can be exercised. The length of the vesting period is designed by the employer to keep valued employees motivated. It is also designed to keep employees from bolting to the competition. Structured properly, an employee stock-option plan with appropriated vesting requirements can create "golden hand-cuffs" that benefit both valued employees and their employers.
Once exercised, employee stock options create a taxable event for the employee. The difference between the current market price and the original exercise price, multiplied by the number of shares covered, is used to calculate the amount of employee compensation derived from the option exercise. By granting employee stock options, employers replace cash compensation that reduces operating income with contingent-based pay that never appears on the income statement. Income statements issued by companies with extensive stock-option plans can dramatically understate the total amount of employee compensation. This can result in earning statements that present too rosy a picture of corporate performance. Such problems become evident when the company's stock price falters, and employees clamor for more cash compensation.
In the long run, investors lose out unless they consider the economic cost of employee stock options.

Questions:

What are Employee Stock Options?

What is the relevance of this Application to risk analysis?

Solution Preview

1) Employee stock options are no longer reserved for the executive suite. Stock options can be expensive to exercise. Improperly exercising stock options can cause real financial headaches, particularly when it comes to paying taxes on your profits. But if you're careful not to overreach, options can be a lucrative benefit. An employee stock option gives you the right to buy ("exercise") a certain number of shares of your employer's stock at a stated price (the "grant," "strike," or "exercise" price) over a certain period of time (the "exercise" period). There are two common types of plans. Employee stock options come in two basic flavors: nonqualified stock options and qualified, or "incentive," stock options (ISOs). ISOs qualify for special tax treatment. For example, gains ...

Solution Summary

The accounting rules for employee stock options are explained.

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