Examining the recent controversy surrounding accounting for stock options, in which certain parties argued that stock option pricing should be treated as an ordinary expense and not a deductible business expense, this article explores what most accountants regard as the ‘good old debate’, looking to establish if – and to what extent – it was valid. In my view, it is, although the debate continues, the evidence of which points to the conclusion that the option’s pricing is a very different beast to the normal cost of the underlying asset.
The argument made by those who opposed the accounting for stock options proposal was that options pricing should be treated as an ordinary expense because of the inherent risks inherent in options trading, in particular the lack of protection for holders of option contracts. The idea is that options are priced below their underlying value, or, more accurately, below the exercise price of the underlying contract, but because the option does not entitle the holder to any cash until the option has been exercised (so the option seller has an incentive to purchase the underlying option at a lower strike price), he/she is not entitled to claim back his/her investment. This argument is based on the idea that options trading is speculative markets, where sellers of options do not have any financial incentive to ensure the underlying contract’s exercise.
As a result, the option seller can, and usually does, pay less than the original price of the option contract in order to secure the right to sell the underlying asset. Although there may be some limited exceptions, such as in the case of financial instruments such as foreign currency options, the fundamental point about option pricing remains. That is, there is a significant difference between the option seller’s ability to recoup his/her investment, and his/her ability to claim back his/her investment.
As far as options pricing is concerned, one important consideration is the fact that option sellers often only exercise their right to purchase an option contract when the option has not yet reached its exercise price. By that I mean, the seller’s right to purchase the option is not available until the option has been exercised by the purchaser – that is, the buyer of the option has bought the underlying asset and exercised the right to purchase the option. This means that an option seller cannot claim back any amount of the profit on an option that has not been sold by the purchaser. under this analysis.
This is another reason why the accounting for option pricing is different to other expense categories. There is a large amount of ‘rebound’ potential from the purchase of an option and the option seller will generally earn more profits from the exercise of an option than he/she would from the exercise of a stock option. Consequently, the option seller will pay much less than the price he/she is required to pay for an option contract when it is purchased.
However, there are also other factors affecting options pricing other than the size of the profit potential for the option seller. For example, the option seller’s risk factor – which is the share of his/her overall profit or loss attributable to the risk of an option contract – can vary considerably. Other than the price and exercise date, there is little else that the seller can do with the options contract until the purchaser of the option exercises the option has exercised. In this respect, the option’s pricing is similar to ordinary stock pricing: the higher the price of the option, the higher the profit that the seller will make and the less the seller will pay when he/she sells the option contract.