Corporate governance and employee/executive compensation are in the news and under increased public scrutiny again. No, the reference is not only to American International Group (AIG), which after posting record losses of $ 99 billion in 2008, has decided to reward some of its 'talented' employees with bonuses up to $ 1 billion for 2008 even as it has obtained nearly $ 175 billion in bail out funds / guarantees from the US government (possibly the biggest bail out of a financial institution in the yet to subside global financial market crisis). Employee / executive compensation in publicly listed and high profile companies has been in the news nearer home in India too.

The Indian developments, of course, do not rank alongside AIG, whose bonus decision has been described as 'outrageous' by the US President's chief economic advisor. (AIG has since scaled down its proposed bonus of $ 1 billion, it is learnt).

They nevertheless shine the spotlight once again on an employee / executive compensation technique which has now found widespread use among publicly listed companies - namely stock options, which confer rights on select employees to purchase shares of their employer-companies at a discount to market prices.

Recent reports about the pecuniary losses running into crores suffered (and being suffered) by IT major Wipro's employees who exercised the stock options granted to them a few years back and purchased Wipro shares (by availing of bank loans) and the multi-crore pay out encashed by the CEO of telecom major Airtel who sold the shares vested in him under Airtel's ESOP scheme, indeed have highlighted the nuances and subtleties involved in this compensation technique. Wipro's employees subscribed to the shares (exercising the options) by availing loans but now their purchase price (the strike price on the options) is much above the ruling market price - courtesy the overall market collapse. On the contrary, Airtel's CEO has been able to generate profits of close to Rs.8 crore by selling shares (even in a depressed market) purchased by exercise of options granted to him.

If stock options are a reward for superior employee performance in the past and to motivate them to beat the market in the future (and thereby benefit the company), the overwhelming nature of systemic market developments has proved this assumption wrong in Wipro's case. The deep slide in the overall market has meant that Wipro has not been able to rise above the systemic problem. In the case of Airtel's CEO, though, the outcomes have been quite positive for the option buyer, since it is clear that despite the fall in the broad market, Airtel's share price was still at a level adequate to generate substantial profits of close to Rs.8 crore.

Going beyond these immediate cases, these developments have served to focus attention on the fundamental economic characteristics of stock options, what they seek to achieve, what is their impact on overall shareholder wealth, the value of the firm and what are the inherent limitations they suffer from in achieving what they seek to achieve.

Why account for stock options?

It is important to reiterate the basic economic characteristics of stock options since it is the economic implications of stock options which make their accounting and disclosure in financial statements absolutely necessary.

Indeed, for a long time, the US corporate sector (the fountainhead of compensation practices such as stock options and employee stock purchases) and, by extension, the corporate sector in other countries argued against accounting for stock options as an expense. These arguments ranged from saying that stock options were no bona fide expense at all since they do not fit the usual definition of an expense. The ultimate transaction which happened if the option were exercised was actually the sale of stock. So where is the expense to be included in the financial accounts of the firm?

The next stage was accepting that options had some value but it was problematic to arrive at that value and expense it. Indeed, options valuation is a hairy topic and is subject to significant differences of perception given that it depends on some factors which are both extremely ambiguous but at the same time important. Price volatility of the underlying asset (be it a stock in the case of stock options, currency, commodity or interest rates) is probably the most ambiguous factor in all option valuation models. In the context of stock options, the probability of vesting and the probability of forfeiture impart additional complexity into the pricing, opening the potential for mispricing and manipulation.

Given this background and given the inherent complexities in option pricing, the corporate sector and the accounting bodies / stock market regulators indeed have come a long way from those days and expense accounting of stock options - based on some commonly accepted methodologies (the intrinsic value or alternatively the fair value method adopting the Black-Scholes formula) - is now mandatory across the world.

The larger economic rationale

The larger issue, though, is the economic impact which the grant of stock options has on the value of the firm and on shareholder wealth. This, as pointed out above, makes it absolutely necessary for financial statements to disclose information on outstanding stock options (and their value) granted to employees so that investors can gauge the potential impact of such outstanding options on their wealth.

And what is this economic impact?

To explain this, consider this example. Assume a company whose shares are now quoting at Rs.100 in the market. This company grants some of its employees the right (the option) to purchase its shares at say Rs.50 on or before a certain date. Further, assume that this right vests on the employees on the fulfillment of certain conditions.

One can straightaway see that the company is selling something (its shares) for less than its market price. Though there will be an increase in assets (cash), there will also be an increase in the number of shares outstanding. To see that the general (outside) shareholders are worse off by this practice, consider the alternative of selling the new share in the market. The market would value the new share and revalue the old ones based on its assessment of the firm's ability to invest the proceeds profitably. If the firm was expected to make as good use of the new equity as it has of the old, the value of the firm would increase commensurate with the increase in outstanding shares, and the stock price should be unaffected (remain at Rs.100). However, in selling the employee the stock at only Rs.50, the firm value would increase less than the increase in the number of shares and, therefore, the per-share value must decline.

This example shows that the exercise of employee stock options invariably involves a loss of value for stockholders and is thus a transfer of wealth from stockholders to the employee. Of course, the loss may be less than was expected at the time the option was issued and the resulting increased effort the executive expends on their behalf may more than compensate for the potential loss in value at the time of exercise. Or it may not.

If the general class or the outside shareholders properly anticipate these effects, the stock price will first respond at the time the option is issued instead of when it is exercised and will adjust as the potential loss in the value of their claims on the firm's assets and net earnings changes.

Overall, the exercise of stock options involves a loss of value to the stockholder, just as real as the gain to the executive or employee. Outstanding stock options represent a liability to the firm in the economic sense, if not the usual accounting sense. This liability represents a senior claim on the firm's assets and a potentially important component of managers' compensation.