ESO (Employee Stock Options) Accounting : New GAAP Standard (FAS 123R) for Enhanced Transparency in Financial Reporting

Accounting for ESO (Employee Stock Options) has been one of the most controversial topics in financial reporting during the last decade. Many employees receive equity compensation as a supplement to their salaries. Traditionally, this compensation comes in the form of ESO grants. This paper describes employee stock option mechanism and underlines rationale for ESO grants. Paper also explains how ESO differ from ordinary call options. In recent years, accounting scandals (e.g., Enron, Tyco, WorldCom) created an environment that demanded more transparent and higher quality financial reporting. Subsequently ESO grants and accounting methods came under increased scrutiny by regulators. FAS 123R is the new financial accounting standard introduced by the Financial Accounting Standards Board (FASB) that requires companies to expense ESO in their income statements using fair value method. FASB sets GAAP in US. Till now companies continued to use intrinsic value method for ESO valuation and do not expense it. Beginning January 1, 2006, it is compulsory under US GAAP to expense ESO in income statement to enhance transparency in financial reporting. This paper also discusses limitations of traditional Black-Scholes model of option pricing in ESO fair value calculation and suggests lattice model as an alternate