Many companies use stock options (which are call options) to incentivize their employees, particularly C-level executives. An accounting rule dating back to 1972 states that these stock options can be expensed at the value of exercise. That is, they can be put as an expense on the balance sheet as the maximum of zero, and the difference between the fair value of the underlying stock and the exercise price of the option.
a. Does this rule over- or under-estimate the expense of stock market options? Explain.
b. Given your answer to (a), do you think that companies are over- or under-incentivized to use option-based methods of compensation?