Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 11 Stockholders’ Equity: Capital Stock and Dividends 501

Stock Options

One method of motivating employees to behave in the best interest of the owners is to

provide the employees with common stock at a discount from the market price. A com-

mon method for doing this is by way of an employee stock option.Over 95% of large

companies use stock option plans to reward employees. Stock options can be very

lucrative for senior executives. For example, stock option gains frequently represent

over half of total chief executive officer (CEO) compensation. Barry Diller, CEO of

InterActive Corp., cashed in over $151 million in stock options in 2003, making him

the highest paid CEO in that year. Such high compensation through stock options has

led to new requirements to recognize options as an expense on the income statement.

Stock options grant an employee the right to purchase common stock at a fixed

price for a limited period of time, as illustrated below. The stock option price is called

theexercise price, and the limited time period is called the exercise period. Stock options

are often granted to employees at an exercise price equal to the market price on the

grant date. If the market price of the stock exceeds the exercise price at any time dur-

ing the exercise period, it is beneficial for the employee to exercise the option. Exercising

the stock option allows the employee to purchase the common stock at a price below

the prevailing market price, which may then be sold to realize gains.

Describe the financial
statement effects of trea-
sury stock transactions.

4

Exercise

Price

Grant Date

Exercise

Period Expiration

Date

Time

Market

Price

Stock

Price

Market Price 

Exercise Price,

don’t exercise

Market Price

 Exercise

Price, exercise

Stock options can have many unique features. For example, the employee receiv-

ing the stock option may be required to hold the option for a period of time until it

can be exercised. Such a waiting period is called a vesting period. Due to the complex

nature of stock options, their accounting treatment is covered in advanced accounting

courses.

TREASURY STOCK

A corporation may buy its own stock to provide shares for resale to employees, for

reissuing shares as a bonus to employees, or for supporting the market price of the

stock. For example, General Motorsbought back its common stock and stated that two

primary uses of this stock would be for stock option plans and employee savings

plans. Such stock that a corporation has once issued and then reacquired is called