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iBio (NYSEMKT:IBIO) has accrued a liability of roughly $4.2 million within the last six months of 2010, which represents over half of the company’s total liabilities and equity. This is only part of the required accounting for options that affects both the financial statements and shareholders through greatly reduced net income and the dilution of stock upon settlement in equity.

Expensing options and warrants (options with a long time period) has been a controversial topic over the past 20 years, involving the FASB, SEC, and Congress at times. Current U.S. GAAP now requires that options be revalued at each reporting date, and any loss be expensed until final settlement [1]. The basic accounting that iBio is using for options, which it plans on settling with its own stock, starts with an increase in compensation expense and an increase in a compensation liability proportional to the gain or loss on the fair market value of the contract. When the options vest (the holder has the right to exercise them) the holder will pay the company cash at the strike price, the corresponding liability will be reversed, and current investors will have their shares diluted as common stock outstanding is increased [2].

Over the last six months, iBio’s net loss was exacerbated by a $4.2 million non-cash option compensation expense. Simply put, an increase in share price has increased the net loss, providing that it was above the strike price and not previously recorded. If on the other hand the share price drops then net income would get a boost, in a conundrum of damning effects for shareholders. Under the current method of recording options, Apple Computers (NASDAQ:AAPL) - as a parallel example - would have recorded net income of $56 million compared to $179 million actually reported under the old method for the 12 months ending March 27, 2004, which demonstrates the extreme effects of option-based compensation on earnings also experienced by iBio [3].

There are a few positive notes relating to the matter; one being that the company receives a tax benefit, and the other is that the company is paying for services with stock, and receiving cash in part, which helps lengthen operations under continuing net losses. Gains and losses from periodic revaluation of options are not actual cash flows, and do not affect operations, like depreciation or amortization in the statement of cash flows.

The big question that shareholders should be asking is "what will be the dilutive effects of exercised options and additional issues of common stock on share price within my period of ownership?" iBio has such a compelling story that it almost overshadows the carnage found in their financial statements. If the company’s production method receives approval from the FDA then it will have a profound impact on COGS within the vaccine industry. Despite that possibility, shareholders need to be cautious, because mild success may be offset by the new accounting practice of treating options as derivative financial instruments, and the subsequent dilution of common stock.

Notes:

1. Accounting Standards Codification (ASC) 718 Compensation -Stock Compensation -Under most circumstances the equity account "additional paid-in-capital" receives a credit offsetting the expense, but in this case a liability account is required.

2. Accounting Standards Codification (ASC) 815-40 Derivatives and Hedging – Contracts in Entity’s Own Equity – The options can be settled in cash or equity, but it is unlikely that cash will be used considering the assets of the firm.

3. Paraphrased from the research of J. David Spiceland PhD., et al., University of Memphis, 2009

Source: What Investors Should Know About iBio's Share-Based Compensation

Additional disclosure: A related party is long ibio.