by Rose Conwell
In the 1980′s many executives of large technical stock analysis were overpaid and were not held responsible for the success of the corporation. To solve this problem, stock options were created. The use of stock options made it possible for corporations to link their executives’ pay with the success of the company.
A stock option is an agreement between a corporation and one of its executives. This agreement gives the executive the right to buy some of the corporation’s stock at a pre-defined price. For example, a corporation makes a stock option agreement with one of its executives to sell them stock at twenty technical stock analysis per share. If the price of that stock goes up to twenty two dollars per share, the corporation must still sell the stock to the executive at twenty dollars per share. This agreement will benefit the executive because they can then sell the stock, which they bought for twenty dollars a share, at a price of twenty two dollars per share. As a result, the executive will make a profit of two dollars on every share of stock that they sell.
Stock options seemed like a prefect way for large corporations to connect their executives’ income to the success of the company. This was done by decreasing the executive’s salary by a certain amount and then substituting that decrease in their salary with stock options. For example, an executive who had a salary of $100,000 a year, would have their salary lowered to $80,000 a year, but they would receive $20,000 in stock technical stock analysis. So, because a percentage of their salary was stock options the executive wanted the company to be successful, so the price of the company’s stock would increase. The more the price of stock increase the more money the executive would make when they sold their stock options.
Stock options originally were not expensed when they were created in the 1980′s. So, stock options were very beneficial to the corporations that used them because the options increased the corporation’s net income. The first year that a corporation included stock options in an executive’s salary, the corporation would record a salary expense that was lower than the expense recorded in the previous year, because that executive’s salary had been decreased. However, the stock options the executive was given, to compensate for the decrease in their salary, was not expensed on the corporation’s books. As a result the corporation’s net income would increase large amount, from the previous year. During this time stock options were almost like free money, because the technical stock analysis were still paying their executives but they did not have to record that money as an expense.
The use of stock options caused executives to want the corporation’s stock prices to increase as fast as possible, so they could make as much money as possible on their stock options. As a result executives started doing irrational things to increase stock prices as quickly as possible. They were basing their decisions on what would increase the stock prices the most, not what was best for the corporation as a whole. So stock options did increase the executives’ interest in the corporation, but they also decreased the logical and strategic thinking of executives. One way executives would get stock prices to increase quickly was they would only concentrate on investments that would create short run benefits for the company, instead of investments that would benefit the company in the long run. This was very risky and made the corporations unstable. Another negative result of stock options was accounting fraud. Executives would also try to increase the corporation’s stock prices by recognizing revenue before the corporation had received it. For example, AOL would advertise their services by mailing CDs with some of their products on them, to potential customers. AOL would record revenue when the CDs were mailed to the potential customers, before anyone purchase their services. Eventually when these companies were caught they were forced to restate their earnings, which caused their stock prices plummet. These scandals forced The Accounting Standards Board to change the Generally Accepted Accounting Principles, in 2004, to require that stock options must be expensed in the year they are issued. This change has greatly decreased large corporations’ use of stock options in the past couple of years.
The use of stock options is not a bad thing, but they must be regulated. Options can be controlled by expensing them in the year that they are issued. Stock options also must have a time limit on how soon the executives can collect their money. Stock options also must have a “claw back” provision. A “claw back” provision enables a corporation to take back options, which were previously issued, in situations were the corporation must restate their earnings. With these provisions in place, stock options can be an effective and beneficial tool for corporations to use.
