Then . . .

In 1995, FASB issued Statement of Financial Accounting Standards No. 123 (FAS 123), “Accounting for Stock-Based Compensation,” which allowed companies a choice of fair value–based method and intrinsic value–based method to account for stock options. Virtually all U.S. companies chose the intrinsic value–based method. This approach measures compensation (stock option) expense at the options’ intrinsic value, defined as the difference between a company’s share price and the options’ exercise price on the date of their grant.

Since these two prices are the same on the date of grant, no compensation expense had to be recognized on companies’ income statements (although the impact on earnings had compensation expense been recorded on the income statement was disclosed in the companies’ footnotes). This lack of expense recognition for stock options permitted a potentially large amount of employee compensation to not appear on the income statement, possibly overstating companies’ earnings.