Recent changes to the accounting rules and tax code have combined to remove much of the flexibility and appeal of stock options. However, there is some good news amidst the gloom – a number of useful stock option practices that were previously impractical are now feasible, including:

• Repricing of Options
• "Net Exercise" of Options
• Performance-based Options

The accounting rules related to stock options have changed significantly in the past year. Prior to the implementation of the latest rules (FAS 123R), companies generally did not record compensation-related accounting charges when stock options were granted with exercise prices equal to the market value of the underlying stock. However, certain practices (e.g., option repricings and net exercise provisions) triggered "variable" accounting – an undesirable result in which subsequent increases in stock prices resulted in new accounting charges. The consequence of variable accounting for option repricings was itself a fairly recent rule and prior to its implementation stock option repricings were common for companies that had experienced sharp drops in the value of their stock. After the implementation of variable accounting rules, option repricings quickly fell out of favor.

Under FAS 123R, which became effective for most companies in the first quarter of 2006, companies are required to expense (take an accounting charge) for stock options and related equity-based awards. The expense is recognized over the vesting period of the option. An actuarial analysis (using the Black-Scholes method, for example) must be done to determine the financial cost of the options and other equity-based awards. While these charges have generally been unpopular in Silicon Valley, many companies are unaware of the good news — which is that the new accounting rules create flexibility to adopt a number of useful practices that until recently were impractical.

REPRICING OF OPTIONS

Stock option repricings, which involve the reduction of the exercise price of outstanding stock options, no longer trigger variable accounting, and there is no significant accounting or tax disadvantage associated with repricings generally. However, companies should be aware of these items prior to any option repricing:
A repriced option is considered a "new" option for tax purposes. This means that the gain on exercise of a repriced incentive stock option (ISO) can only be treated as capital gains if the stock is held for at least two years from the date of the repricing and more than one year from the date of exercise...

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