Now let's consider how a company accounts for stock options. When a company grants options to its employees, it is essentially giving a portion of the company to them in the form of future shares. There is an accounting issue, though because the company is giving value to its employees, but is not incurring a cash expense as part of this transaction. Now, the value being given away is provided to the employee on the grounds that the employee will provide a certain number of years of service. The vesting period. The accounting therefore introduces an expense into the income statement that reflects the value that has been given away in exchange for the services received. The expense the company recognizes is based on the fair value of the options at the grant date.

This is known as a grant date model. This grant date model means that even if the share price were to skyrocket during the vesting period, the expense recognized in earnings is unaffected. The only thing that affects the expense recognized is the fair value of the options on the grant date. The fair value of the options is amortized over the vesting period and treated as an employee cost. So the expense matches the value given to the employee over the period which the employee has earned that value. This means if the options were valued at 100 on the grant date and our vesting period was four years, we would spread the fair value of the options across this time period given an expense of 25 each year. The expense is non-cash and included alongside other employee costs, meaning it can usually be found under the selling general and administrative expenses, or SG&A line options are settled either by issuing new equity or by purchasing shares in the market. So after the vesting period, the company has two options for how it can settle the share options. It can either create new shares or go to the market and purchase them at the market price. Whichever option the company selects, it does not impact the expense incurred. The process of granting options dilutes the value for other shareholders. The employee receiving the options is able to purchase shares at a discount.