Your example and my example actually are not correct saying that cash is turned into an expense when paid, I just stated that for simplicity. Now on to a hopefully better explanation about why options need to be expensed.
The expense is incurred when the person works. How you pay them is up to the compensation structure in place. Currently employees are usually paid in cash plus another currency called options. By only showing the cash expense, you are understating in the P&L statement the true cost of operations. The thinking is that employees are working for less cash compensation in exchange for the options. So if the options stopped, if the theory holds any water, then the cash compensation would have to go up to attract and retain the talented people necessary to perform the work. I don't agree with this premise because I think if the real cost of the options was shown as an expense, their use would decline dramatically.
Let's go to another example. Harry works for no cash compensation. Does that mean that his services have no expense associated with them? In exchange for his services he takes restricted stock units which are just another form of equity in exchange for his services. This is a barter transaction that has costs associated with it. I do not know the rules for accounting for RSU's but the fact remains that for the past year Harry was given 50,000 RSU's. I believe they are given on the date of the ASM. So on that date last year, the stock was worth somewhere around $15, I think, so he received compensation on that date of $750,000 less a discount for the fact that there are restrictions associated with it. Shouldn't this be recorded as an expense?
The same is true for other executives who at times in the past with other companies have forgone cash compensation in lieu of options, I think Larry Ellison did this if my memory is correct. Should Oracle not show any expense on the P&L since he did not get paid any cash? Wouldn't this be misleading since in order to compare Oracle's cost structure to other companies, you need to show an expense for the CEO?
Now if option's do get expensed, and I really don't care what method is used, there will be a truer picture of how much it costs to operate a company. Without the cost showing up in the P&L, the cost gets ignored. I don't care what you pay someone with, the services are rendered, which means an expense is incurred, and there should be a measurement in the P&L to reflect what it costs to operate. It is much simpler than the press makes it out to be.
The main impact that expensing options will have is it will reduce their use since it will have a negative impact on reported earnings. Many companies management are paid bonuses based on reported earnings, and it is total earnings, not EPS. By excluding options from expense, it increases total net income thereby increasing management's bonuses and they are fat and happy. The only problem is the people who invested in the stock, whose capital is at risk, are being fleeced at the same time. Something must be done to curb the abuse and reflecting it in the footnotes has no impact, maybe showing them in the P&L will have the desired result. My only fear about this is that then analysts will exclude this in their proforma statements. (That is one thing that needs to be stopped immediately, pro forma statements, but that is for another rant.)
ISO's are nothing more than a barter transaction. In a barter transaction you need to record both sides of the transaction. Let's say you give inventory in exchange for services. In effect you have a sale of the inventory which reduces the balance sheet item (inventory) and increases revenue (the sales account). In addition, you have an expense for the value of the inventory.
The only difference between the above example and the issuance of stock options is the fact that when a company sells an equity stake, the sale is not a P&L item, it occurs only on the balance sheet. So when equity is sold it increases an asset, cash, and increases equity, paid in capital. Now when the cash is used to pay for goods or services it results in an expense. In the case of employees the expense is called salary, wages or bonuses, it makes no difference, there is an expense.
In a barter transaction called incentive stock options, you would increase equity by the issuance of the option, then record the expense. The expense would then flow down to retained earnings which would reduce the total equity amount and bring the balance sheet back to the same position before the issuance of the options. The P&L for that period would properly reflect the cost of the employee services and everything would be in balance. You could then properly measure what the true income for the period was since all expenses were shown on the income statement.
If you choose to ignore this expense what is the justification for showing any other expense on the income statement? Why not just have 1 number on the income statement called revenue and disclose all other expenses in footnotes? There is no difference and all should be properly reflected to properly measure a companies costs.
One last thing in this long drawn out post is to respond to your other example. You said:
"Consider this example: If an employee loaned money to the company i.e. received a debt instrument in the company (assume zero interest for simplicity), then you would not consider that as negative wages, would you? Of course not, because the loan is documented as a BS transaction, until it is repaid or whatever acutally happens to it."
Your example is truly a balance sheet example which is not what the granting of options are for services rendered. There is no P&L impact to the receipt of cash for a loan. But let's take your example one step further. Let's say this employee and the company at a later date decided to forgive the loan in exchange for stock options. What would happen then? Should this loan forgiveness show up on the income statement? No it shouldn't. What would happen is the debt would be written off and the paid in capital would be increased. Now when the employee first loaned the company money, what was it for? If it was to pay for services of other employees, those services would be recorded as an expense on the income statement. Just because the loan was ultimately forgiven in exchange for the options would not mean that the original recording of salary expense should be reversed does it?
I guess option accounting is more difficult for non accountants to understand after reading your posts. I know you are very financially savy but even you are having trouble with it, so the average Joe is going to be lost in the whole debate. Unfortunately those in congress will listen to the companies who are supporting them and the above discussion will not take place and congress will probably try to override FASB again, although this time I believe it will be much more difficult.
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