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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?"
How is the offer of options a "fiduciary responsibility incentive"? With an option, you have no downside, so you have an incentive to gamble all the firm's money on producing a temporary rise in the stock price.
Perhaps this was a typo for "fiduciary irresponsibility incentives"?
Options are issued from an "options pool". In any company large enough to be subject to FASB rules, that pool has already been set aside for that purpose. The dilution happened to the early investors (angels, pre-VC folks, etc.), which it was a small private company.
While I'm not as knowlegeable about financials as I should be, wouldn't expensing options also give companies a massive tax break, too? Seems like they would. They'd hit the bottom line, but tax savings would be tremendous, which would offset some of the "loss" proposed by doing this.
Aside from the fact that expensing options makes for more accurate financial statements, it reduces a company's tax burden, thus making them more profitable in reality (rather than just on paper).
I think it's a horribly dumb idea to pump up corporate profit on paper just so the tax man can take a bite bigger than your real profit out of your fake profit. I guess that's one of the problems with publicly traded corporations though - shareholders are often too uneducated to realize that long-term gain is more important than short-term illusion of profit.
I claim first use of "Error No. 0B" - or "No. 0B error." It'll be the new ID 10T!
Will my stock be worth less when those options are exercised, en masse, by employees fleeing a sinking ship? If the answer is yes, then companies should expense stock options.
In fact, it's amusing that this even requires discussion. Options are like any other debt, except that the eventual cost of paying off that debt is unknown. Companies are required to report outstanding debt. Why should options be any different?
Slashdot is my Mercer Box.
I've worked at dotcoms and now a large company which gives out stock options to its employees. Until i joined the large company I didn't realize the value of options (not a get rich scheme).
If companies have to expense options, they'll drop the option programs as the expensing will kill profitability. Therefore companies will nolonger give out options (MSFT has already stopped giving out options), and thus the major $$$ form of compensation will be salary, and salary does not keep an employee at a company for a long time, as you can jump ship to another company easier to get a raise than to ask mgmt.
Plus many companies spend big $$$ repurchasing stock on the market to keep up the stock price.
Lastly, if options are expensed then only the execs will get options and not the workers in the trenches.
HockeyPuck ---> .
Goodwill, to first define, is the premium paid for another company above what they are physically worth (buildings, equipment, patents, etc.) Therefore, if Co. A buys Co. B for $20 mil, and there are only $15 mil of physicaly goods, $5 mil is goodwill.
So the question now, is why expense (impairment is the technical term) it if the value of goodwill goes down? Because it is a consistent treatment of company especially intangible goods. If a company has a 15 years of a patent left to amortize, and for whatever reason it is invalidated, or maybe a new advance comes out making that patent obsolete,the comapny should properly impair the value of the patent, just as goodwill is now treated.
Two things we accountants like are comparability and consistancy. impairment of goodwill brings both of these to the table. After all, if SCO had any goodwill in the accounting sense, they should probably write off quite a bit of it, as they have likely drastically reduced the value of said goodwill.
thng
Actually, in most cases, stock options are all ready prevented from insider trading. This is how it typically works: you get hired by a company and has a hiring bonus they give you some shares. Also, every X days, you have an option to buy more shares at an 'option' price (usually the market low during the X days). At the same time you have an option to buy shares, you can sell them. Because you can only buy or sell during designated times, you can't time your option purchases around news from your company. Most insider trading cases involve people in the company calling up their freinds with 'tips'. Normal shares are used.
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Crudely Drawn Games
C'mon people... let's admit our limitations. There are very few of us qualified to even form an opinion on this matter (not that that usually stops us) and those few will just be drowned out by all of the crappy assertions made by the rest of us.
/So how 'bout them HP laptops?
Options are nothing more than a promise to offer stock to someone at a fixed price in the future. If that fixed price is less than the market price, the company misses out on possible capital. This is the amount that people want to turn into an expense. How the heck do you account for that ahead of time? If you wait to account for it when the option gets exercised, it skews your earnings reports because of it reflects prior payroll, not current payroll. You can't just go back and drop it on the books for the date the option was given, because it'd be years before you could finally close the books on a given fiscal year.
In short, there is no simple answer for this question, so quit trying to find one and let the bean counters figure this one out.
Corporate expenses are incurred when a corporation buys something. A stock option, even when exercised, does not cost the corporation anything. It's a con game, to make less costly, high-growth infotech companies, which offer more options than industrial corporations, seem to cost more. Next they'll allow tax writeoffs for "opportunity costs", like letting Lockheed cancel its puny tax liability because it invested in laser missile defense instead of gas pipelines.
What else do you expect from the president who appointed the head of Alcoa, the practically medieval aluminum mining and manufacturing company, his first Secretary of the Treasury? Who proved unable to do anything to assist the bubble's soft landing, even when the rest of the White House would talk with him? The only thing President Vice President Cheney likes about tech companies is that they waste a lot of expensive electricity - so he'll make their finances as complex as possible, requiring his buddies at Anderson *cough* Enron *cough* Accounting to get their piece of the action if they show any green - cash - at all.
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make install -not war
Yes, Buffet makes an excellent argument. However, consider some of the negatives. Companies will be expensing something that has no cash cost. Therefore, they will be deducting the opportunity cost of those options (fair market value if they had sold them to an outsider) from their income. Does this really make sense?
Right now, companies already expense the cost of the capital appreciation of the share sold when the option is exercised. How? Stock buybacks. When a stock option is exercised, the employee is sold a share out of the option pool (which usually means there's no dilution). The company books this cash as a share sold, just as if it was sold on the open market (but at the lower option strike price instead of fair market value). Eventually, that share is bought back (most companies continuously buy back shares) and the cost of that buyback is expensed. What is up for discussion is if/how to expense the option value of the option, not the capital appreciation of the underlying share.
Also, consider that many of these options will go unused, either because the employee leaves the company before they vest or because the options are underwater when they expire. The FASB recommendation permits companies to make allowances for these situations, but those allowances will always be wrong. The FASB permits similar allowances for bad debt and other estimations on the pro formas, but those entries are made up of many transactions, and they will statistically approach a historical value. Stock options are typically granted to many employees at once with the same strike price. This will appear as a single transaction-- instead of multiple, offsetting errors, companies will have single, large errors. This will drive more volatility than the other estimations on the pro formas.
I agree with Buffet that options clearly have value-- otherwise employees would not value them as compensation. I also agree that some method should be employed to correct the pro formas for options. But, the two major mechanisms recommended were designed to estimate fair market value, not the impact of an opportunity cost to a company's financial situation. I think using them in this way is not accurate. In fact, I think it will make the pro formas less accurate.
In the interim while we wait for the accounting wizards to come up with a better solution, I think it makes sense to just continue doing what most companies do today. If you look the 10-K for most companies, you will find extremely detailed option data. Using this data, you can compute the "expense" to the company in any way you find best. If the SEC requires companies to bake this in to the pro formas, it will be much more difficult to unwind the financials to use your own technique.
Yes, it will be more effort than just looking at the Net Income line or doing a quick ratio (or a Quick Ratio). But, investing in individual securities is not for amateurs (and I include myself if this category). That's what mutual funds are for.
Options are priced using the black scholes method (though typically it is a modified BS model.) Everyday thousands of options are traded on the open market using BS as the pricing method.
There is no reason that options shouldn't be expensed. Options are used as employee compensation. You expense payroll why WOULDN'T You expense options.
FYI In the foot notes you do get the number of outstanding options and their diluitive effect on the outstanding shares but nobody reads the footnotes. Hell I think most people don't even read the financial statements.
I have benefited from stock options in the past: not enough to be wealthy, but enough to give me a pool of savings to last the year-plus I have been out of work so far.
However, I favor stock option expensing, even though it would most likely reduce the number of options that are awarded to employees (since the company would have to bear an increased accounting cost for each option that is awarded). The reason is that it is more honest. The profit from exercising stock options comes out of the pockets of the stockholders who were suckered into paying full price for the stock! As a stockholder, I am annoyed that optionholders can "stealth" themselves from company expense reports, as is currently done.
Microsoft has a truly good idea, that I read about a while ago: issuing real shares of stock, not just options. This neatly avoids the entire debate regarding the accounting of stock options. Employees would be paid in real shares of stock, in addition to cash. This has all the benefits of encouraging employees to take a stake in company performance, as options do, and motivates employees to want to make the stock price rise.
Issuing real shares of stock would easily be accountable, and would also have added the benefit of being fair to all employees, not just the few who got in early and got the coveted "below-a-dollar" options....
Dr. Demento On The 'Net!
Expensing stock options will not make executives more honest. You could ban options all together and the execs would find another way to line their pockets. The current problem with options and executives is that it creates a pump and dump incentive. Execs can show a good quarter or two, talk up the prospects and then dump their dump stock at a tidy profit. Fixing this really requires stronger corporate governance rather changing accounting regulations.
If the corporate boards really represented shareholder interests, there wouldn't be this problem since those boards would not allow compensation packages to execs that ran counter to the shareholder's interests. I'd start by banning board membership by anyone who works for the company in any other capacity, CEO included. Board members should only give execs options that are exercisable after several years and at a premium to the current price to account for inflation. This way the execs would have to create some lasting shareholder value to reap a windfall.
The expensing formulas can't capture the real value of the option. The only real way to figure out the value of the option would be to make them tradable and not expire on termination of employment. The proposed formula's are just a bean counters guess and will underestimate the value for companies that do well in the future and will grossly overestimate the value for companies that do poorly.
Furthermore, putting non-cash charges into earnings reports makes it really hard to understand the reports for those of us who didn't go to business school. It's already almost impossible to figure out what a companies cash flow from operations was from an earnings report because of all the stupid non-cash charges like goodwill amortization. Goodwill amortization is much like stock option expensing in that it makes the bean counters feel better but confuses everyone else. It's a lot easier for the dishonest to cheat when no one can under earnings reports and balance sheets due to the cluttering off them by make believe (non-cash) charges
Stocks are "worth" what anybody is willing to pay for them -- a stock quote is just the going market rate at that point in time. Companies that give shares of stock as options are simply agreeing to sell the shares at a pre-determined price, either absolute or as a percentage of the market rate (depending on how it works at the company in question or in the contract).
Imagine I have 3 million widgets which other people are willing to pay me $50. But I like you, so I say, "benzapp, you're doing a good job. I'll give you a widget for just $2 instead of the $50 that other people would pay for it." Now you can buy it from me and turn around and sell it to some sucker for $50. That's where the $48 magically appears -- it's not "gone" anywhere, it came out of someone else's pocket.
"You can never have too many elephants on your team."
So the question is, what's the most disadvantageous for Microsoft?
According to Bear Stearns, there would be a 60% drop in profits if the new rule were imposed. Think about it. Earnings in high tech companies are so dependent on stock options that these companies will "experience" a huge drop in profitability. Conversely, how can you support an accounting trick that buffs the profit of the industry by 150% (the reciprocal of a 60% drop)?
Bottom line. Profits are grossly overstated industry-wide. Why shouldn't we have accounting that reflects that reality? Why should we let this fiction continue? Are we going to forget the lessons of the dotcom bubble? Accounting tricks do work. And investors and employees can and are scammed by them. Finally, why do we need to fight so hard to get valid information about a company? It's just wasting our time which collectively is more valuable than that of a few company accountants.
See here for more discussion of this particular story. That's where I got the link BTW.
I think several of your guesses are rather lousy. Listing the options as expenses does not take a single dollar out of the company bank account.
What it DOES do is validly reflect that it *does* cost the company value to have granted those options. Had the company not issued those options they could have sold those shares at full market value and had that much more cash. Effectively that *is* what the company is doing, and handing that cash to the optioned employee.
The difference between giving the emplyee that option and him selling the stock, and the company selling the stock and giving the employee the option value in cash, it is pure bookeeping games. The final result is the same therefore the final accounting totals should be the same.
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- - You can't take something off the Internet! That's like trying to take pee out of a swimming pool.
Stock options are a fiduciary responsibility incentive because it links the fate of the option holder to the health of the company. (as measured by stock price) The downside with options is the loss of sweat equity on the part of the recipient if the option proves to be worth nothing and the dilution of equity if the option proves to be worth something. If you as executive gamble all the firm's money on a *temporary* increase in stock price then you're the type who would otherwise just wire the firm's money directly into your personal account in the Grand Cayman Islands anyway. What you're supposed to be doing is risking the firm's money on a *permanent* increase in stock price. You know, adding value? Now, you might argue that options give people incentives to make risky decisions. And you would be correct in that. Such stocks have correspondingly high betas. But putting money or sweat equity behind innovation is itself extremely risky.
For God doth know that in the day ye eat thereof, then your eyes shall be opened, and ye shall be as gods
No, you're guessing wrong. Like the parent post said, his options aren't worth anything, and chances are he is not going to be offered any options any time soon.
The people that should be worried are the *executives* of the company. Nowadays, the only people benefiting from options are top executives. When their options aren't worth anything, they simply reissue themselves a new batch of options at a more attainable strike price.
Assume company X has $100 million in actual cash profit one year, but grants options to employees that the SEC makes them record as $100 million of expense. Does that mean they did not make a profit, and thus do not have to pay any taxes on the cash?
The latest Slashdot meme.
stock option grants do not, in principle, influence cashflows(otherwise it would have been impossible not to expense them). on a practical level, they influence where the cashflows go, i.e., in management's pockets instead of the shareholders'. even when used in a startup they should be reserved against, but I agree that it would be impossible to expense them right away.
one of the key issues, tough, is:
at what strike price options should be granted?
the strike price of an option is the price at which i have the possibility, but not the obligation, to receive the underlying stock. if the stock price is already ahead, the option is "in the money", meaning that if I could exercise it now, i'd make a gain.
since options can be exercised only in future dates, intereest rates come into the picture, but broadly speaking, we can say:
options granted at prices below or close to the going price of the shares = cokmpensation;
options granted at prices higher than the going price of the shares + interest at going rates = incentive.
there was a going joke in the good ol' days: the whole of Enron management goes to a strip joint to celebrate another good year of hard work. one of the ladies, after a bout of pole-vaultin', goes on all fours to one of the guys, looks him in the eye and says " I'll do anything for you. absolutely anything." and quickly, he answers:
"reprice my options"
( repricing is a practice by which companies lower the strike price of the options granted, whereby making them much more valuable)
"If a boss demands loyalty, give him integrity. But if he demands integrity, give him loyalty." (John Boyd, 1927-1997)