Page 472 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

458 The Complete Guide to Executive Compensation

Market Stage

Item Threshold Later
Reason Retention Performance

Eligibility Extensive Selective
Dilution High Moderate

Vesting Four to five years One to three years
Price FMV Performance

Reprice Share-for-share Unlikely
(How?) ↑ Common ↓ Prorated

Ownership Stock held Stock held
definition unexercised option

Table 8-39. Variances in stock options by market stage

(assuming a 40- percent rate is in effect). If par value of the stock is $1, par value of $1,000 is
added to the par value account for the additional 1,000 shares now outstanding, and $99,000
(i.e., $100,000 $1,000) is added to the capital surplus account (also called the additional
paid-in capital account) resulting from the savings in taxes, for a total increased retained
earnings of $123,000. However, had the company sold the stock at $160, capital surplus
would have been increased by $159,000 (i.e., $160,000 $1,000). Thus, the option has
“cost” the company $26,000 (i.e., $159,000 $123,000) or the portion of the $36,000 gain
not reimbursed (i.e., $60,000 less a $24,000 reduction in taxes).
Another way to evaluate the cost of stock options is to determine the extent of dilution
to equity. A popular method for calculating this is the treasury method. This assumes that the
proceeds from the stock option plus any tax benefit received are used to purchase shares of
the company stock on the open market. Dilution is therefore a function of spread of
market value over option price. For example, using the same 1,000 shares described above
at an option price of $100, the company received $100,000 from the executive plus
$24,000 (assuming a 40 percent tax rate) in tax benefits from the $160 market price. This
$124,000 can be used to purchase 775 shares at $160 a share. Thus, the dilution of equity is
225 shares.

Advantages and Disadvantages of Stock Options. As shown in Table 8-40, the advantage
to the executive of the ISO is that there is no tax at time of exercise. The disadvantages are
that the maximum number of shares is limited by the grant cost (e.g., number of shares times
option price cannot exceed $100,000 in one year) and the spread between option price and
fair market value at time of grant is subject to tax preference income. The nonstatutory
option has reciprocal advantages and disadvantages.
Advantages and disadvantages to the company are shown in Table 8-41. Nonstatutory
stock options are more advantageous to the company from a tax point of view. There is no
difference in accounting treatment between the two types of grants.