The financial statement impact of stock options is an often-misunderstood subject for investors.

This column will explore the impact of stock options on the balance sheet and income statement. It will also include an example of the impact of options on diluted earnings per share. By Phil Weiss TMF Grape October 12, Last month I wrote an introduction to stock options in which I reviewed the compensation aspects, the primary advantages and disadvantages, and the different types of options that can be granted.

I'd like to continue this series with a discussion of the impact of stock options on the balance sheet and income statement. My discussion tonight will center on non-qualified stock options NSOs. If you're not familiar with that term, please head back to my introductory column. One of the biggest objections to accounting for stock options is that the vast majority of companies do not record any compensation expense related to stock option grants. As a result, these companies, which account for their options under APB 25 the original accounting principal describing the treatment of stock options under US Generally Accepted Accounting Principles GAAP are not allowed to deduct the income tax benefit realized from the exercise of such options.

Instead this tax benefit goes through the equity section of a company's balance sheet. In many cases you can see the amount of this benefit reflected in the Statement of Changes in Shareholders' Equity. Since accounting is a double entry system, the other side of the change to shareholders' equity is a reduction of income taxes payable to the IRS. Treasury Stock Method The accounting rules do, however, require that the tax benefit mentioned above be reflected in the calculation of diluted earnings per share EPS , which is calculated via the Treasury Stock Method TSM.

In short, the TSM assumes that all the money in stock options are exercised at the beginning of a financial period or the date of issue, if that's later. The reason that this method of calculating EPS is called the TSM is that it uses the proceeds from the hypothetical exercise of stock options to repurchase shares of stock -- such shares are called treasury shares.

Cash Flow Statement

This actually serves to reduce the dilutive impact of stock options. Don't worry if this sounds a bit confusing.

I'll provide an example of how this works shortly. There is actually a recent accounting standard FAS No. However, this alternative, which charges compensation expense for the fair value of options granted to employees, is largely ignored.

One company that does follow this accounting pronouncement is Boeing Airlines NYSE: If you take a look at its income statement , you'll see this cost reflected in the line called share-based plans expense. By following FAS No. Now let's try and put some numbers behind what I've been talking about and see what happens. In working through this example, we'll assume that the options are accounted for under APB 25 and that the companies record no compensation expense for the grant of at-the-money stock options.

You may want to take a short break before going through the example. Go get yourself something cold to drink and a calculator as well, since the only way I can think of doing this is to run through a bunch of numbers and calculations. First, we need to make some assumptions about how many options were actually exercised in order to calculate the balance sheet impact.

It should be noted that in this part of the example, I'll only refer to the actual options exercised.

In the second part, I'll refer to the total number of options outstanding. Both are needed to determine the full financial statement impact. It should also be noted that the ultimate purpose of the second part of the calculation is to determine how many additional shares the company would have to issue over and above those it could repurchase with the proceeds from the stock options exercise in the event that all the outstanding options were exercised.

If you think about it, that should make a lot of sense. The purpose of this whole calculation is to determine diluted EPS. We're calculating the number of shares that have to be issued to arrive at the diluted share count.

Number of options exercised: The treatment of stock options on the cash flow statement will be discussed more fully in the next installment of this series. Next, we'll need to add some more assumptions to see what happens to EPS: Income statement impact None directly. As noted above, the company in this example has chosen to take the traditional approach to stock option compensation and has not deducted any compensation expense in its income statement.

However, one cannot overlook the fact that there is an economic cost to stock options. The failure of most companies to reflect stock options in the income statement has led many to argue that this failure results in an overstatement of income. The issue of whether or not such amounts should be reflected in the income statement is a difficult one. It is easy to argue that excluding the impact of such options from book income results in income being overstated; however, it is also difficult to determine the precise cost of options at the time of issue.

Employee Stock Options and Ownership (ESOP) - benefits

This is due to such factors as the actual price of the stock at the time of exercise and the fact that there are employees that will not become vested in the options that they are granted. Earnings per share impact When calculating diluted EPS, you assume that all in-the-money options are exercised at the average stock price for the period 25, shares under option in this example. These proceeds are then used to purchase shares at the average stock price 15, shares.

This figure is then subtracted from the total number of in-the-money stock options to determine the incremental shares that would have to be issued by the company 9, It is this figure that results in the increase to the total shares outstanding for the diluted EPS calculation.

You'll probably find that the difference between basic and diluted EPS in this example is a bit larger than normal. In the next part of this series, I'll discuss how stock options are treated in the cash flow statement.

If you have any questions on what's been presented here, please ask them on our Motley Fool Research Discussion Board. An Introduction to Stock Options Some Thoughts on Stock Options Optionmania!: Make it inline block later.

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Part 1 , Part 2 , Part 3.