A stock option is a contract between a company and its investors that gives them the right to buy or sell underlying stocks at a preset price within a specific time period. Just like ordinary stocks of a company, its stock options are also available for trade on stock exchanges. These options may come at a higher or lower price depending on when they were listed originally. In addition to stock options traded on the stock market, companies may also issue stock options to their employees. Employee stock options allow the employees of a company the right to purchase shares at a predetermined rate and period of time.
The price of a stock option is directly related to the price of the underlying stock. If the price of the stock fluctuates, the option will also change accordingly. Similarly, stock options can have other characteristics too. Stock options come in two types, calls and puts. A call option allows the investor to buy shares at a set price within a predetermined time. On the other hand, a put option allows the investor to sell shares at a predetermined rate within a predetermined time.
Stock options also have a strike price, which is the price at which investors can exercise the stock option. Likewise, stock options also have a premium, which represents the profit for the company selling the option. The premium depends on the price the buyer pays for the option. Usually, it will also depend on the price of the underlying stock in the market.
Stock options also have a grant date, a vesting date and an exercise date. The grant date is the date on which the company grants these options. The vesting date is the date on which the buyer obtains the right to exercise the option. The period between the grant date and the vesting date is known as the vesting period. Lastly, the exercise date is the date on which the buyer exercises the option and buys the underlying shares.
Accounting Treatment
The accounting treatment for stock options depends on the different dates related to them. First of all, when a company grants stock options to investors or employees, it does not require any accounting treatment. That is because, at the grant date, the stock options do not have any effect on the company.
As mentioned above, the period after the grant date but before vesting date is known as the vesting period. The vesting period of a stock option may span over several years. Therefore, at the end of each accounting period, the company must estimate the fair value of the number of equity instruments expected to vest through stock options. Once the company determines the fair value, it can expense it out as follows:
Dr Compensation Expense/Asset
Cr Equity (Stock options)
On the exercise date, when the buyer buys the shares, the company will record the payment as follows.
Dr Cash
Dr Equity (Stock options)
Cr Equity (Share Capital)
Cr Equity (Share premium)
In the above accounting treatment, the company reverses the equity recognized as stock options and recognizes share capital and share premium, if any.
Valuing Stock Options
There are different models for valuing options. The earliest model is called the Black-Scholes option pricing model which provides an analytical, closed-form formula for valuing a European option.
Binomial option model is used to value American style options. The model relies on the assumption that for the next time period, a stock can move up, or down with certain probabilities. The major advantage of the binomial model is that it’s relatively simple.
An option can also be valued using Monte Carlo simulation. The simulation is carried out until the options’ maturity. We then apply the terminal payoff functions and calculate the mean values of all the payoffs. Finally, we discount the mean values to the present and thus obtain the option value.
Conclusion
A stock option is an instrument that a company offers to its investors, which gives them the right to buy or sell the stocks of the company at a set price within a specific period of time. The company may also offer stock options to its employees. The accounting treatment of stock options depends on the vesting period and exercise date of the option.
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