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?"

Comments

Warren Buffett's take on it

[Chris Mattern]

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

Re:Warren Buffett's take on it

[khallow]

Options, when granted, are not an expense. They don't cost anything and have no value. Only when they are exercised do they have value, and that may or may not happen. We should keep the status quo, where options are expensed only if and when they are exercised.

No. We have tools (eg, Black-Scholes valuation model) for calculating the value of options. Consider insurance companies. They get a great revenue stream from all these people they insure. But with that, they get liabilities which may or may not occur. It would be incredibly stupid for an insurance company to ignore an insurance liability on the grounds that it might not occur. Otherwise, in good years you might earn an extraordinary profit, and in bad years lose it all and go bankrupt because you didn't keep track of the liabilities.

Stock options are potentially huge costs to a company. Ignoring those costs is foolish.

Not IF but HOW

[schwaang]

Realistically, options are an expense and pretending otherwise on the balance sheet is just gamesmanship.

Excerpting from this recent article about the issue:

The most potent criticism of the board's draft proposal to expense options when they are granted, came from an unlikely source: Mark Rubinstein, a finance professor at UC Berkeley's Haas School of Business, who helped develop the method.

"I was one of the inventors of the (board-proposed) model, and I say: Don't use it. It doesn't work," Rubinstein said. Companies should have to expense only the amount that an employee profits after he exercises the option to buy the stock, Rubinstein said.

That came as a surprise to the FASB board members.

[The FASB board is the federal advisory board that's hashing out what should be done about expensing stock options.]

Yes "duh".

[nodwick]

Uh, no. Stock dilution happens because the number of outstanding shares changes. The earnings and growth numbers that are used to valuate shares are calculated per outstanding share, so any change in shares outstanding creates dilution. Look at any company's 10K or 10Q; they'll have two lines listing earnings per share (EPS) and diluted EPS separately for precisely this reason: diluted EPS is what the company would earn per share if all the options were suddenly exercised.

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.

Re:No way!

[swillden]

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.