Slashdot Mirror
Should Companies Expense Stock Options?
A reader writes : "The New York Times is running a story about proposed accounting changes to force companies to expense stock options. Is this a necessary and proper oversight measure to enforce financial discipline on companies that might otherwise have none? Or would this measure basically stop companies from offering fiduciary responsibility incentives to their employees? What do you think about this? What should the final decision be? And what measures should be taken to influence the decision-making process?"
The most incisive analysis of expensing stock options I ever heard was from Warren Buffett, who can surely claim to know what he's talking about in financial matters: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?"
Chris Mattern
Excerpting from this recent article about the issue:
[The FASB board is the federal advisory board that's hashing out what should be done about expensing stock options.]
It actually has absolutely nothing to do with insider trading.
Insider trading is when a person who has inside (not public) information about a company acts on stock (buys or sells) because when the information becomes public they believe the stock will take a turn one way or the other. This person may or may not be an employee of the company and for the most part this is done with normal shares, not options.
Book income is not the same thing as tax income. Most financial statements provide a note to the financials that detail the differences between the numbers.
This would affect book income, not taxable income.
The REAL issue with whether options should be expensed or not is whether the diluted EPS captures the full effects of dilution through options issuance, or if there are hidden costs. There's a non-zero "option value" to the options (the choice not to exercise if the stock price drops), that is distinct from the "intrinsic value" (roughly equal to the strike price minus the current price). The argument is that this is presently not captured in the accounting regulations.
For more info on share dilution, check about.com's primer. There's also a section in there on common tricks companies use to hide dilution effects.
If you think Enron and Worldcom cooked their books, just wait until you see how the "expense" of stock options winds up being calculated.
They'll play with it, of course, but how can expensing the options at any positive value be worse than the status quo? Most companies currently take no hit whatsoever for issuing options; it seems much better to argue about whether the cost ought to be larger or smaller than to ignore the cost entirely.
It's just as bad as requiring businesses to value their "goodwill" and take an earnings hit when it "goes down".
"Goodwill" does not mean what you think it means. It's not the case that businesses estimate the dollar value of their reputations, as the word might seem to imply. It's a trick used to account for what happens when a company purchases another company. Suppose you want to buy my business, which consists of a factory and other physical assets, a large, loyal customer base, an excellent, widely-recognized brand and a bunch of great employees. Clearly, the employees, the brand and the customer base are all valuable to you, and are the real reason you want to buy my company. But the employees, great as they are, are an expense from an accounting point of view, and the customer base and the brand are irrelevant.
So, suppose you agree to pay me $100M for my company, and the factory and tangible assets are only worth $20M. That means your balance sheet will show a $100M debit and a $20M credit. On paper, your company just lost $80M by buying mine, even though everyone agrees that my company's future earning potential is well worth $80M, because of the above-mentioned factors. It would be inaccurate to show that the value of your company declined by $80M as a result of the purchase. Maybe the value went up, maybe it went down, but as far as anyone knows now, it was a fair price, meaning you got what you paid for, so you broke even, from an accounting point of view.
The solution is "goodwill". Your accountants will record a $100M debit to cash, a $20M credit to tangible assets and an $80M credit to "goodwill". If, a few years later, you determine that that division of your company is now worth only $60M (fair market value), because the market for its products declined, or you just didn't manage it well, then you will reduce the "goodwill" on the balance sheet accordingly and take that hit as an expense. Assuming the factory is still worth $20M, my "goodwill" is now worth $40M, so you'll apply a $40M expense, reflecting the actual decrease in value of your company.
I'm sure I've got this at least partially wrong, hopefully a real accountant will chime in, but that's the gist and it is a sensible approach to solving a real problem.
Note to ACs: I usually delete AC replies without reading them. If you want to talk to me, log in.
Yes, you are correct NineNine, that their is a tax benefit. The only thing, is that tax benefit doesn't occur until the option is exercised, whereas the expense is to be recorded at the time of grant.
Yours,
Jordan
I'm sorry, but that is just wrong. The idea that stock options don't have a clear value will come as news to all the investment banks in the world that trade options, and have to mark their P&L accounts to market every day. Beginning with Fischer Black and Myron Scholes in 1973, there has been continuing work in developing models to value options. The key insight is that the option has a value that is a function of the current price of the underlying stock (or other asset); it is also a function of the price volatility of the stock, the time to expiry, and the term structure of interest rates.
Of course, the potential future value of the option is not certain, but so what? The potential future value of the company's stock or debt is not certain, either, and that does not prevent their current value being reflected in the accounts.
I worked in IT in investment banking for 20+ years. In a couple of cases, I wrote the bank's documentation on our methods of valuing options that was submitted to the regulatory agencies (e.g., the SEC). Some of those options were one-off, OTC transactions that were much more complicated than ordinary stock options, but I never heard anyone suggest that they didn't "have a clear value."
Two problems. First, until the option expires valueless, it'll always have some value (particularly if it's well above water). Second, it's deceptive to ignore the cost of options until the last minute. Accounting should reflect reasonably well the actual value of the company. Allowing a company to hide real expenses like options means that you have to search harder to find the information that should be readily available. Making this change reduces the tactics that a company can employ to hide excessive compensation.
For example, it's doubtful that the board of the New York Stock Exchange would have missed the scale of the compensation package they approved for the former CEO Dick Grasso (which incidentally was well above the annual profit reported for NYSE). That's because the accounting would reflect the expense of the pay package and turn the "profit" that the NYSE reported into a significant loss. As it was, Grasso didn't have to report his compensation package until the cost showed up in the accounting.
"Stock options are the most powerful incentive we have to attract employees," Andy Bechtolsheim, a founder of several Silicon Valley companies, including Sun Microsystems, told the demonstrators. "Why else would someone leave a large company and take the risk" of joining a start-up firm?
Without options, three out of four start-ups that succeeded in Silicon Valley would have failed, because they would not have been able to attract high-quality employees, Mr. Bechtolsheim said.
This does not make sense!
A start up is not public. They do not have to put out a report to the public every quarter. Expensing options do not have much of an impact on start ups.
And companies can still give stock options if they expense them. They just will not look quite as profitable on those quarterly statements.
Religion is the main cause of atheism.
Some people, myself included, will simply not invest in any company that does not expense options.
Other people will gladly take risks in companies that do whatever the hell they want in granting and expensing options.
Maybe one party will make money, maybe both, maybe neither; you pays your money and you take you place at the table WRT betting on risks/rewards.
Of course I realize that I have little chance of catching the next totally hot startup, but I've studied a hell of a lot of accounting and IMO a company is only as good as the accounting method they use; anybody throwing money around in the market who doesn't know GAAP and SAP and the difference betweent them is a fool- they still might be a lucky fool, but still a fool.
"Everyone is entitled to their own opinion, but not their own facts."
That's not relevent here. The proposed changes are to accounting practices. Tax law is unaffected. All that is changing is the way in which expenses are computed. Specifically, stock options will now have to be included in total expenses that are reported. Currently, they are reported seperately. Companies argue that they will have to reduce the options they hand out becuase reporting higher expenses to their shareholders will result in a lowering of their share price. Proponents of the change argue that share price will not be effected.
The real problem here is that when the accounting changes go through, a number of companies will react based on the belief that keeping options in place will negatively effect them. So they respond to this threat by eliminating the options plans. Unfortunately, that decision is most likely going to negatively effect them. So, the change will probably have negative effects on some companies even if they bring them upon themselves.
Nobody is FORCED to take their company public; they do so to obtain cash from outside investors. Naturally, no investor wants to put cash into something that won't pay back, and our country has established some "fair play rules" that boil down to
.03% of the 3000 largest companies in the country.) Inconsistent, hidden, or buried-in-footnotes numbers just are humanly impossible to work with. And they're against the spirit of public ownership of companies.
1) management's acknowledgement that they work for the new owners, as exemplified by accountability to a Board of Directors that is meant to protect the owners' interests, and
2) management will prepare honest and accurate accounting of what's happening to the company that they're running.
Options are only recently a significant part of a company's total financial picture, and so only recently have become important for investors to understand. After investors take a stab at whether, say, Palm One is going to make it or not -- neat ideas, good engineering, rapidly changing market and uncertain prospects -- they also have to consider that if the firm is financially successful, they mightn't get much to show for risking their funds.
My clients have a few billion dollars, mostly middle-class retirement funds, at stake. They expect reasonable risks and a fair chance at a good result. The elementary math of investing is that many investments are losers, or have a very modest payback. It's the relatively few that succeed that make stocks good investments. If those few don't actually pay you -- unknown options give half of it to employees -- then the whole deal turns sour.
As many posters have mentioned, expensing options doesn't change the CURRENT working status. As an investor, I'm happy to see creative carrots for important employees, but I absolutely MUST have a good feel for what fraction of the company's success is committed to somebody other than me. The challenge is for me to make a decent swag at the company's future earnings that my clients will get. (My clients own about
I strongly support using options as an incentive to employees, but I also strongly support a standard, consistent way of accounting for them. If firms don't want to provide investors with a consistent, "generally accepted" picture of what they are doing, they shouldn't be offering stock to the general public.
"Inquiring Minds Want to Know!"
There are people in this world - those traders on Wall Street - who know very well what the value of options are.
They buy and sell options every day for real money, and they don't pay a cent more or less than they're worth. These guys get paid real money - in the hand - for trading options. Do you think that money's illusory as well? Do you seriously think that banks pay their employees for making illusory profits?
Read my lips - options have objective and tangible value, which everyone who participates in the options market agrees on (they just think differently about the future price).
Anyone who says differently either doesn't know what they are talking about, or is just blowing smoke.
You can go around in circles as much as you like but those are the facts.
Now consider this:
The USA is the only major country that does not expense options
Despite that, a number of US listed companies (start-ups and others) that sell to Wall Street DO expense options. If they didn't they would have zero credibility.
So if you believe options are cost free, then you'll have to accept that both people who know (ie. Wall St, London etc), and the rest of the world think you've got rocks in your head.
And while a lot of people in the US might agree with you, you're just a member of a large group of people who are living in la-la land.
More seriously, the improper treatment of options is one of the largest on-going fiscal scandals of the past 10-15 years. Options transfer money from public shareholders to insiders.
I guess my question is, "what is the benefit of expensing options over the current way of doing things?"
A great read on the subject is Warren Buffet's 1992 letter to shareholders. It's a ways down - the section is called "Two New Accounting Rules and a Plea for One More" and it's in the second part of that section. Anyway, to answer your question:
1) Options have value, otherwise they wouldn't be given as compensation.
2) Value which is given for a service should be expensed.
Now, the trouble comes with the valuation. There are several methods of option valuation, each of which has their shortfalls:
1) Market price of options: basically you look at the going rate for the kind of options you are giving, and you expense that. However, this has several problems:
* the leverage of potential options on current stock shares are not included in the books right now, so a loss from options expensing will decrease book value, although that value was never on the books to begin with
* you need to unexpense unused options, which leads to unnecessary volatility when options expire
2) The Black-Scholes option-pricing model. Basically, this says that if you give an option, you are forgoing cash that you could have received immediately from the sale of that stock. Therefore, the cost of the option is basically interest on a loan of the value of the stock - it's basically the same way you might expense an interest-free loan.
One of the problems with this model is again that you are charging expenses that aren't on the books - you would not have given yourself an expense had you done nothing with the stock.
3) Warren Buffet's method - I can't remember what this is at the moment.
One other issue with stock options is that it dilutes the value of stock. Let's say, for instance, that you have issued 1,000 shares of stock, and you keep 1,000 shares in your treasury. That year, you make a profit of $1,000. You then distribute it to the shareholders, who get $1 each. However, let's say that you grant all of the remaining 1,000 shares from your treasury in the form of options, and all of the options are exercised by the recipients. That means that all 2,000 shares are in circulation. So, if you make the same profit of $1,000, each shareholder only gets fifty cents. However, these numbers are reflected in the dilution of stock.
Engineering and the Ultimate
Publicly traded companies and private start-ups have completely different needs with respect to options accounting. For publicly traded companies, expensing options is desirable for providing better information to smaller individual investors. For private start-ups, accurate expensing is not feasible and not necessary because individual investors should not, usually cannot, and mostly do not invest in such companies. For public companies the leading issue is to make the financial statements as helpful as possible for outside investors with limited resources to make a quick decision about a stock. If you have the time to read all the footnotes and run your own BS model to value the options, you don't need to rely much on the income statement treatment of options. Smaller individual investors need to rely on income statements to a greater extent. Failure to expense options means such investors might miss the fact that a company's apparently high performance was purchesed by high compensation of executives or that the company was being looted by executives through excessive stock option grants. For publicly traded companies there is much more information about the volatility of the underlying common stock (a key variable in any options pricing model, such as BS. Privately held companies have insufficient common stock pricing events for such a volatility estimate. In addition, the outsiders investors are typically sophisticated angel investors and/or venture capitalists, mezzanine investors, or friends and family investing based on trust of the insiders. This is a vastly different scenario. At some point the investors might want the company to switch to expensing options
This year IBM shareholders voted to expense stock options. The Board of Directors recommended voting against the proposal for expensing options as it obviously effects CEO compensation but the shareholders wanted it anyway.
As other posters have pointed out - this effects other employee stock programs such as some Employee Stock Purchase Plans depending on how the company sets them up.
Ah, but they do.
Employees will take stock options in lieu of cash to some degree, so issuing stock options lowers the cost of paying employees wages here and now in this fiscal year.
Then, in later years when the employees exercise their options, the other stockholders take in the shorts as the pool of shares dilutes their worth.
In some ways, it's like issuing a bond but paid back in shares instead of cash when it finally comes due...
"Provided by the management for your protection."