Smaller Corporation has been in operation for several years. Each year, at Christmas time, the company has given a cash bonus to each of its employees, and properly recorded the bonuses as compensation expense. Smaller has reached the point at which it is now making a reasonable return on its stockholders’ equity. At the end of the current year, the president of the company is considering establishing a compensatory share option plan for Smaller’s key executives, instead of paying cash bonuses to any of its employees. At this time the market price and the planned option (exercise) price of the company’s common stock are the same. The plan would allocate a specified number of options to each executive based on the executive’s level within the company and meeting the company’s targeted income goals. The service period would be three years and the options would have to be exercised within 10 years.
You are the controller for Smaller and one of the key executives who would participate in the plan. You also already own a substantial number of shares of Smaller common stock. The company president comes to you for advice about this plan and says, “If Smaller Corporation establishes this plan, it will work out for all of us. It looks like the plan is pretty valuable, since an option pricing model shows a high fair value for each option. The corporation will be saving cash because it won’t have to pay bonuses to either the executives or the other employees. But executives will manage better because their share options will depend on meeting the company’s targeted income. Since the market price and the option price are the same, there won’t be any compensation cost or expense related to this plan. Furthermore, since no bonuses would be paid to any employees, the corporation will decrease its compensation expense. This will increase its net income and earnings per share compared to last year, as well as its return on stockholders’ equity. So the stock value will go up. This seems like a win-win situation for everyone. Am I right on this? Do you think the company should adopt this compensatory share option plan?”

Required
From financial reporting and ethical perspectives, how would you reply to the president?