Should Companies Expense Stock Options?

Fiduciary responsibility incentives? by Anonymous Coward · 2004-06-27 08:05 · Score: 5, Interesting

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"?

Re:Fiduciary responsibility incentives? by fname · 2004-06-27 08:50 · Score: 4, Insightful

Ya, I thought the same thing. It forces one to question if the submitter even understands what an option is.

I've had long discussions about options with my friends. I finally realized the only sensible objection to stock options. And that is they have no impact on the cash position of the company. When a company is small or newly founded, it doesn't really make sense to value options, as at that point the cash poisition of the company is the overriding concern; this allows start-ups to offer compensation that, while not equal to that of larger companies, offers a tremendous possible upside to employes. Once cash flow is no longer really concern, it's convenient to continue to give options, as it doesn't count against the income statement. At this point, Warren Buffet's words quoted elsehwere (if options aren't compensation, what are they; don't we expense compensation?).

In short, options for start-ups make sense, and no one really cares what the GAAP earnings are-- cash flow is much more important. For established companies, cash flow is often difficult to relate to the success of a company, so using GAAP earnings makes sense, and options should be expensed. And I have no idea what "fiduciary responsibility incentives" are, and the submitter doesn't either.
Re:Fiduciary responsibility incentives? by thrillseeker · 2004-06-27 09:33 · Score: 4, Insightful

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.
Options granted to employees are nearly always restricted in many fashions. For one thing, a percentage of the total grant is frequently vested over time - often 20% per year, giving a 5 year time period before fully vested. The company usually has the ability to call the options - that is, demand payment of the strike price - the average employee holding 20,000 options at $5 is probably going to be hard put to come up with $100,000 if demanded of him - most people would have to borrow on it, and you'll find few banks willing to loan against a privately held stock. The last time I checked, even a publicly held stock could only be borrowed against at 60% of market value. Many option holders would simply say "fergetaboutit" rather than go into debt on such a thing. Also, there may be peanlties associated with early "termination for fault" - i.e. you do something dumb and get fired and you lose all your stock options. Even once the options can be converted to tradeable shares, as a company insider many employees might be required to file public documents with the SEC announcing their intent to sell - now the world knows of their intent and can react accordingly.
The whole debacle about expensing them is about the biggest irrelevant effort made in a decade by the Financial Accounting Standards Board. In a public company, any investor that knows the difference between a put and a call is going to have his own rule of thumb for the value of an option - after all the thing is simply a promise that a share may, if desired be purchased at some time in the future - it's got nothing to do with the present day financial health of a company, and is a very hazy factor in the future potential value of a company's shares.
Expensing options is nothing but a big press deal - disclosure of options is all that is needed, and that is required to be done in publicly held companies already. A clear rule set of how they should be disclosed would be beneficial, but it seems no one is talking about that.
Re:Fiduciary responsibility incentives? by Chazmyrr · 2004-06-27 10:27 · Score: 4, Insightful

The 5 year vesting often only applies to the lower ranks. Top level executives often receive options with either no or shorter vesting periods.

But lets put that aside for a bit. The real problem is that not expensing options is far too easy to abuse. Company grants options for 50 million shares. When options are exercised, company issues 50 million more shares. This doesn't impact the company bottom line at all. There is still no expense incurred. The only measurable effect is that earnings per share goes down. Then after several years of this, the company takes a one time charge to repurchase the stock they issued to cover the options.

That's not even taking into consideration the dilution of ownership caused by excessive option granting.
Re:Fiduciary responsibility incentives? by johnlcallaway · 2004-06-27 10:40 · Score: 2, Interesting

Stock options do impact the cash position of a company, but not in the way you think.

In privately held companies, stock is issued depending on the perceived value of the company and what monies investors have put up. While there is no true value, this stock is an indication of what percentage an investor 'owns' in a company. If the company is sold, the proceeds are split up depending on the stock ownership. It is not uncommon in those instances too for all options to become immediatly vested, the same is true of an IPO event.

As part of the intial funding, it is not uncommon for companies to set a specific amount of stock to be issued for internal use, often with very specific vesting periods to entice employees to stay. When employees leave, they are often required to excercise those options within a specific period or they are lost. When excercised, those funds are then made available back to the company. Of course, an employee can buy options at any time once they are vested, but I don't know if any reason to do so in a private company since there is no one to sell them to. I can see a reason for 'expensing' these options so that the later funds received offset them.

Now, here is where it gets fun. After an initial investing round, companies are often enticed by other investers or pursue new ones, and the games begin. The new investors try to convice the company that the company is not worth that much so they can get a bigger percentage of the company. The current investors don't want that to happen because whenever someone buys in after they have, their shares get 'diluted' because new shares have to be issued. Someone who owned 10% of all shares now only own 9.1% because 10% more shares were issued to the new investor to get their $50M.

The current investors want the money from the new ones, but they don't want it at the risk of losing a significant percentage of ownership. Of course, this can all be easily dealt with if everyone who invested before chips in, but even that is fraught with one-upmanship games.

In a roundabout way, this game the companies cash position. The number of stock issued (including options), their perceived value, and the future perceived worth of a company all impact the ability for companies to entice new investors. While this cash position is not tangible, it is very real and can make or break a company. If the company needs cash but has over extended its stock, it makes it very easy for a new investor to come in and set their own terms, sometimes diluting current shares to the point they are not worth anything.

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I rarely read replies, it's my opinion and if you thought about your opinion a little more, I'm OK with that.
Re:Fiduciary responsibility incentives? by nelsonal · 2004-06-27 13:18 · Score: 2, Interesting

The advantage is that a better estimate of option cost will be in the headline EPS number that everyone follows. Currently companies are allowed to expense only the intrinsic value of options. This is always zero, since companies issue options at the current stock price. As a result of this treatment, companies give away too many options (since the cost is too low).
It's getting a ton of political pressure because current option plans really do not do a good job of aligning shareholder and management issues. The goal of these plans is to make a considerable amount of management's pay to be based on the same (or similar incentives) as shareholders have (increasing stock prices, preferably faster than competitors). The political issue is that management only has to increase the stock price long enough to cash out their options, and may engage in risky behavior in the hope of a one time payoff. A better plan to do this would be to lengthen the period when an owner cannot exercise their options and index the strike price to either an index (like the S&P 500) or a group of competitors. ie if you issue options at $100, and after the first year the average return of your competotors was 10% at the end of the first year the new strike price is $110. If you couldn't exercise for 10 years, this would be much closer to what shareholders want.
The black magic comes from the Black-Scholes model, which uses an estimate of volitility to estimate value based on the chances that an option will finish in the money.
Companies already do have to report numbers, and estimated value, of options issued, the ranges of strike prices of options outstanding, but this information is not used on the income statement, which is all most investors look at.
Personally, I'd like to see operating cash flow reduced by the amount of cash required to not dilute current option related stock issuances, and see option plans that were longer and indexed (all but the crappiest company didn't go up over a 10 year period, which is all current options require to start transfering management value).

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Re:Fiduciary responsibility incentives? by johnnyb · 2004-06-27 21:21 · Score: 2, Informative

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.

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Engineering and the Ultimate
Re:Fiduciary responsibility incentives? by 4of12 · 2004-06-28 01:53 · Score: 2, Informative

...stock options. And that is they have no impact on the cash position of the company.

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...

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"Provided by the management for your protection."
Re:Fiduciary responsibility incentives? by johnnyb · 2004-06-28 07:07 · Score: 2, Insightful

"So, if expenses don't reflect cash-flow (or what cash-flow should be, if people paid on time), what do they do? (this is rhetorical/sarcastic, I know that expenses are, but have never understood their usefulness. What really matters to me is money in the bank, what's being spent, where it's being spent, and what income is coming in. Expenses just muddy that into oblivion."

Then I hope you never have to manage a company. Managing a company is all about managing non-cash assets and expenses, because they will all affect your cash positions someday. The purpose of accounting is not to find out how much money is in the bank. You can do that just by calling the bank or keeping a check register. The purpose of accounting is to know whether or not your current practices are (a) healthy, (b) profitable, and (c) sustainable. It also helps you understand when you should expect your money, how much money you should be able to expect in the future, how much work you have left to do, what expenses you might have to fill in the future.

For example, if I win a housing contract that's $1 million dollars that I get paid up-front, I have gained NOTHING. What I have done is simply shifted my positions. I have $1 million more in assets, but I also have $1 million worth of liabilities (I still have to build the house - it's not a cash liability, it's a service liability). If I make the sale in December and then do the books on a cash basis, then it looks like I made $1 million profit, when in fact I don't even know if I'm profitable yet. I won't know that until the house is finished.

Likewise, if you are paying your employees in stock options, and not estimating the value of those options, you won't know if you're really profitable or not. If you wind up running out of options, you might find that the _real_ compensation package that they expect is 10x what you are paying them now, and that what you thought was a profitable operation was in fact just a drain on your "options" asset. However, since you were only doing books on a cash basis, you didn't see the true costs of doing business, and didn't realize until years later that you were truly unprofitable.

Likewise, if you don't factor in the cost of money into your operations, you might wind up making less than if you just stuck your money into the bank. In fact, the insurance industry is a giant play on the cost of money. Insurance companies actually often lose money on the premiums-vs-payouts, but make money by making loans off of the float.

So yes, there is more to accounting than just cash-flow, and it is vital to determining profitability.

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Engineering and the Ultimate

Accuracy by BobPaul · 2004-06-27 08:06 · Score: 3, Insightful

Mr. Casey acknowledged that "perfect accuracy isn't possible." But he added that "lots of other things in accounting are impossible to measure with perfect accuracy."

But at least other things in accounting can be measured with modest accuracy.

Re:Accuracy by HMA2000 · 2004-06-27 09:10 · Score: 3, Interesting

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.

Well duh. by Senator+Bozo · 2004-06-27 08:07 · Score: 5, Insightful

Options dilute the value of the company stock, and since shareholders are the owners of a company it only makes sense to list them as expenses.

Re:Well duh. by jonatha · 2004-06-27 09:07 · Score: 2

Having read many of the posts here I understand why so many .coms went bust. The geeks running them didn't have the faintest concept of accounting...

I oppose the expensing of options because there is often no good way to value them, particularly in the case of a startup offering them in lieu of cash (which is often where they do the most good from the business's point of view, and where rules requiring them to be expensed are likely to hurt the business's viability the most).

Option grants and the associated potential costs are already required to be disclosed in the footnotes to a company's financial statements. If the rules do wind up changing (as seems likely, or perhaps even inevitable), the financial tricks companies play with their stated earnings will make the recent financial engineering of pension returns look like chump change. (Even Black-Scholes requires the person using the model to make a number of assumptions, some of which are open to abuse...)

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Re:Well duh. by susano_otter · 2004-06-27 09:23 · Score: 2, Insightful

I'm guessing that if your company expensed the options, it would make their financial situation significantly worse.

I'm guessing further that if the stock options are expensed, the "possible layoffs" will become "definite layoffs".

I'm guessing still further that the reason your company is spamming you to oppose option expensing isn't so much because they care about preserving your job, but because they care about preserving the company itself (and all the jobs in it).

I'm guessing still further that you took a gamble when you accepted options as compensation, probably because it seemed like a good idea (or the lesser of two evils) at the time, and that you're complaining overmuch now that your gamble hasn't paid off.

I'm guessing that you're definitely complaining overmuch, considering as how you haven't left the company in spite of how much you claim to hate them.

And it's the last one that really bugs me. I figure, you must have some compelling reason to stick with this company, even though they took all your hard work and failed to turn it into a strong, profitable business plan.

If you insist on working at this company, then shouldn't you also insist on doing whatever you can to prevent the company from laying you off and/or going out of business?

What do you gain by working there, that you would not gain more of by opposing option expensing?

Make up your fucking mind: either support the company you work for, or quit. Staying on the payroll while working through acts of commission and omission to undermine and weaken the company is both immoral and just plain stupid.

Or are you one of those "any job worth doing is worth doing badly" people?

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Any sufficiently well-organized community is indistinguishable from Government.
Re:Well duh. by Alsee · 2004-06-27 17:47 · Score: 4, Interesting

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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Re:Well duh. by stephanruby · 2004-06-27 18:54 · Score: 2, Interesting

I'm guessing that if your company expensed the options, it would make their financial situation significantly worse.
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.

Cost of stock options by nuggz · 2004-06-27 08:11 · Score: 4, Insightful

Yes it is a good idea to link company and employee performance. But when something is given the value must be recorded.

Options have value, and people will pay for them. By giving them away the company is basically giving away money. To say there is no cost is not accurate, and the owners deserve to have the most accurate picture of comapny finances available.

Re:Cost of stock options by einhverfr · 2004-06-27 08:49 · Score: 2, Insightful

IANACPA

Options have value, and people will pay for them. By giving them away the company is basically giving away money. To say there is no cost is not accurate, and the owners deserve to have the most accurate picture of comapny finances available.

The question is how you record them.

No, they are not an expense when they are issued.

No, they are not an equity when they are issued.

Yes, they are an expense and an equity when they are excersized.

Given the volitility of the stock market, what IS the expense of an option?

If I were creating an accounting system for this (and I am not a cerfied public accountant, though I do my own accounting for my business), I would do as follows:

1) Create a liabilities account for the strike price of unexersized options. And an expense account for losses on exersized options.
2) When an option is issued, it becomes a liability, which is usually paid with equity.
3) When an option is exersized it is paid with equity. The equity is deducted at *full market price* and the balance is debited to the expense account for option losses.

This seems pretty accurate to me. But the balance sheet will NOT show what the actual expenses are. Basically it makes the whole financial document system that much harder to navigate.

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LedgerSMB: Open source Accounting/ERP

Taxes by NineNine · 2004-06-27 08:11 · Score: 2, Interesting

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.

Re:Taxes by Lupulack · 2004-06-27 08:20 · Score: 4, Interesting

Yes , the companies would get a tax break by this ( their taxable earnings would be lower ) , but a lower earnings would also drive their stock price down.

Imagine the effect on stock price of everyone's favorite enormous software company if they were to report employee stock options as expenses. It would nearly wipe out their earnings , which would drive their stock price down precipitously. Which amusingly enough would also drive down the value of the stock options themselves ...

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The fact that no one understands you doesn't mean you're an artist.
Re:Taxes by BigHungryJoe · 2004-06-27 08:32 · Score: 2, Informative

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.
Re:Taxes by jordandeamattson · 2004-06-27 09:01 · Score: 2, Informative

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

YES! by Stile+65 · 2004-06-27 08:13 · Score: 2, Interesting

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.

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Warren Buffett's take on it by Chris+Mattern · 2004-06-27 08:14 · Score: 5, Informative

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 by khallow · 2004-06-27 08:58 · Score: 4, Informative

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.
Re:Warren Buffett's take on it by bnenning · 2004-06-27 09:06 · Score: 3, Insightful

The most incisive analysis of expensing stock options I ever heard was from Warren Buffett

A response to Buffett is here.

I agree that stock options are a form of compensation; it is very clear that they are. But is the next step where I disagree. It does not necessarily follow that the company suffers an operational expense. Rather, it is the shareholders who pay for the compensation through dilution of their existing shares. Stock options cannot both be an expense to the company and a dilution of shareholders' stock; that would be double-counting.
I have to agree. Issuing options (or additional shares) imposes a cost to existing shareholders via dilution, but the total value of the company is unchanged. The company is just transferring equity from one group of investors to another.

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Re:Warren Buffett's take on it by mgoff · 2004-06-27 09:08 · Score: 3, Interesting

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.
Re:Warren Buffett's take on it by johnnyb · 2004-06-28 03:04 · Score: 2, Insightful

However, they miss the fact that if they had given the _same options_ on the open market they could have been compensated for them. Instead they gave them to employees. Clearly if you have something of value (no matter what it is) and you give it away instead of selling it, you are incurring an expense are you not?

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Engineering and the Ultimate

That depends. by gr3y · 2004-06-27 08:15 · Score: 2, Interesting

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?

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No way! by JohnQPublic · 2004-06-27 08:15 · Score: 2, Insightful

Stock options don't have a clear value. Since you can't say "12,000,000 options are outstanding and excercisable, at a cost to the company of US$120M", you can't apply it as an expense. If you think Enron and Worldcom cooked their books, just wait until you see how the "expense" of stock options winds up being calculated. It's just as bad as requiring businesses to value their "goodwill" and take an earnings hit when it "goes down".

Re:No way! by swillden · 2004-06-27 08:58 · Score: 4, Informative

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.

--
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Re:No way! by richg74 · 2004-06-27 09:24 · Score: 2, Informative

Stock options don't have a clear value. Since you can't say "12,000,000 options are outstanding and excercisable, at a cost to the company of US$120M", you can't apply it as an expense.
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."

Don't mix things up! by retostamm · 2004-06-27 08:16 · Score: 4, Insightful

I think one of the major problems in this discussion is that the Stock Options for the CEO types (equivalent of about 1000 employees options, if you count them) can cause wrong and fraudulent reporting in order to sell off the stock.

Individual Employee's options are a great way to retain employees, keeping them motivated and having them think big picture, but they just can't fake the bottom line.

And guess who's options would definitely go away?

--
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Not IF but HOW by schwaang · 2004-06-27 08:18 · Score: 5, Informative

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.]

Re:Yes by azulcactus · 2004-06-27 08:21 · Score: 3, Informative

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.

Wrong by Tod+DeBie · 2004-06-27 08:27 · Score: 3, Insightful

Expensing stock options as proposed is not a good idea. Despite what many suggest here, it will not produce a clearer picture.

If you expense stock options when granted, you have to make an estimate as to their value/cost and use that in the financial statement. The problem is that, when granted, stock options do not cost anything to the company and have no dollar value, and they may never. It is likely that in most cases, the estimated value when they are expensed will be revised when the options are exercised.

Right now, companies do one of two things when options are exercised: they either grant new shares, diluting the existing stock; or they buy back shares (or use shares already held back) equal to the amount exercised so as to not dilute the stock. Both methods have their merits, but the point is that it is only at the time of sale when the true cost of the option is known. So why change the way things are working? I suppose we could force all companies to buy back instead of dilute the share pool, but, I really don't see any case for expensing them when granted.

Options should only be expensed when they are exercised, which is exactly what happens today. Why do we need to change?

!options then compensation = salary by HockeyPuck · 2004-06-27 08:33 · Score: 3, Interesting

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 ---> .

Re:Not IF but HOW, [ expense only the gains?? ] by PenguinOpus · 2004-06-27 08:40 · Score: 2, Insightful

Stock options have value and should be expensed somehow, but to "only" expense the gains when the employee exercises and benefits leads to all sorts of counter-productive results.

As CEO, I work hard to increase share price to benefit the shareholders. I somehow achieve my goal, then all my employees (including me) exercise/sell to reap the benefits. Suddenly my earnings take a huge hit. Boom, my stock price crashes. Sure, I could call it a one-time charge, but option exercise/sell is basically out of my control and could happen every quarter. In the end, shareholders and financial analysts would have to ignore this aspect of my earnings, which brings us back to the situation we have today.

goodwill by Thng · 2004-06-27 08:43 · Score: 3, Interesting

. It's just as bad as requiring businesses to value their "goodwill" and take an earnings hit when it "goes down".

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

Stock dilution by nuggz · 2004-06-27 08:45 · Score: 2, Insightful

Every single additional stock dilutes my share of the company.

The only way to stop this is to buy back stock, which is a huge expense.

Yes "duh". by nodwick · 2004-06-27 08:45 · Score: 5, Informative

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:Value of options by Tod+DeBie · 2004-06-27 08:48 · Score: 2, Insightful

They do have a cost, just it is an unknown future cost.

Yes, but that future cost may be zero. The employee may leave before the options vest, or the options may never get above their strike price, hit their experation date and disappear. The future cost may be zero, or it may be significant. Today, public companies list their outstanding ESOP on their 10K SEC filings, and then either buy back stock to compensate for exercised options, or just let the options dilute the share pool. Either way, investors have all of the data about the options out there and how they will be managed. If any cost is actually incurred, then the company will report that. What is wrong with that?

Re:Yes by Valar · 2004-06-27 08:51 · Score: 3, Interesting

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

Consider SCO by Nakito · 2004-06-27 09:00 · Score: 2, Insightful

Indeed, there is no necessary correlation between a company's stock price and its profitability or even its value to society. SCO is a fine example. The factors that drive stock prices can be completely independent of the factors that drive profitability. If incentives were based on profit sharing, or sales, or other tangible positive values, instead of stock options, the incentive would be to make the company profitable rather that to drive up its stock price. Accordingly, stock options may well create an incentive to breach fiduciary duties rather than to support them.

Re:Consider SCO by Chazmyrr · 2004-06-27 10:07 · Score: 4, Insightful

I would rather they didn't. It leads to short term business practices that damage the company in the long term. The executives responsible have already cashed out and moved to another company before the negative consequences start to show in the bottom line.

As an example, the corporation for which I work use to own a number of large facilities around the country. The land and buildings were owned outright so there were no loan payments to consider. A few years ago, all of the facilities were sold with the new owners granting a 20 year lease. This made the bottom line look really good that year. A few years later the rental expense is a significant impact that could have been avoided.

The executives who made that decision don't care. They made millions from it. Many of them took offers from other companies.

So, what's the solution? I don't know. I do know that executive stock programs have only made things worse.

Re:Value of options by khallow · 2004-06-27 09:36 · Score: 2, Informative

Yes, but that future cost may be zero. The employee may leave before the options vest, or the options may never get above their strike price, hit their experation date and disappear. The future cost may be zero, or it may be significant. Today, public companies list their outstanding ESOP on their 10K SEC filings, and then either buy back stock to compensate for exercised options, or just let the options dilute the share pool. Either way, investors have all of the data about the options out there and how they will be managed. If any cost is actually incurred, then the company will report that. What is wrong with that?

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.

Giving real shares and not options by Krellan · 2004-06-27 09:48 · Score: 2, Interesting

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....

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Dr. Demento On The 'Net!

expensing won't fix anything by jay2003 · 2004-06-27 09:52 · Score: 2, Interesting

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

Value of Options by wx327 · 2004-06-27 11:08 · Score: 2, Insightful

If you wanted options on X shares of stock at K strike price that expire in T years, I would sell you those options for some premium P. What's the value of P? It's the amount that should make me indifferent from selling you this option or not. Read up on Black-Scholes for option pricing formulas that basically use information on the current stock price, K, T, the risk free rate of return, and the volatility of the stock to determine the expected payout of the option.

Now after I sell you these options, they can change in value due to many things, such as stock price movement, changes in the financial outlook of the company, etc. The fact that I am now short call options to you means that I have a contingent liability to you on expiration to deliver X shares in exchange for the agreed upon stock price. I have potentially unlimited downside on this side of the transaction, if the stock price should skyrocket. But theoretically, I am on average compensated for this risk by the premium you paid to me to get these options.

Flip now to me being a company. You want options, and I give them to you, without charging you the premium. Had I gone and sold these out on the marketplace, I would have taken in P. This is not being expensed. If I want to unwind this position in the future, so as to remove the contingent liability, I'd have to pay P2 in the marketplace.

Whether or not you expense options, if you issue them at all, you are forgoing P. And in both cases, you have a contingent liability. Being short call options is potentially costly.

Can any company be short options on anyone else's stock in their investment portfolio and not have that liability noted on their books? I think not.

Private start ups by BroncoInCalifornia · 2004-06-27 11:33 · Score: 2, Informative

From the New York Times article:
"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.

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Let the market decide by Tri0de · 2004-06-27 11:40 · Score: 2, Informative

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.

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"Everyone is entitled to their own opinion, but not their own facts."

no, stock-options are NOT an expense by dh003i · 2004-06-27 12:03 · Score: 2, Insightful

Stock-options are a share-dilution. They are not an expense. You cannot count stock-options as both an expense and a dilution of shares; that's double-accounting for them.

See The Great Accounting System

The Stock Market, Profits, and Credit Expansion

Accounting for the Austrian School

Should Stock Options Be Expensed

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social sciences can never use experience to verify their statemen

The Financial Account Standards Board disagrees wi by benzapp · 2004-06-27 12:34 · Score: 2, Insightful

Nothing you posted has anything to do with the most important issue: STOCK OPTIONS ALLOW PEOPLE TO BUY STOCKS AT GREATLY DISCOUNTED PRICES.

Where does that money go, hmm? If a stock is $50 per share today, and you exercise your option to buy that stock for $2, what happened to that $48?

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I don't read or respond to AC posts

Prevents Insider Trading by yintercept · 2004-06-27 12:43 · Score: 2, Insightful

There is almost always a vesting period, and employees only get to exercise an employee stock option once...so, I can see merit in the argument that employee options cool the impulse for insider trading. In most cases, the strike price is determined by the hiring date of an employee. Employees do have leaway to determine when they sell the stock. There is a very strong temptation for employees to hold onto options until they leave the company. The longer you hold your employee option, the more valuable it becomes. The primary reason for employees selling options is to purchase things. This even holds for CEOs who might exercise a set number of options each quarter.

With employee stock options, employees only have one trade...they get one chance to sell. The only risk of insider trading occurs when a stock is over valued. Their insider trade, of course, helps temper the rise of an over valued stock. I really don't see that much harm. The one trade reduces the losses of outsider investors.

The real power of options come with the fact that an employee can hold the options for several years with the value of the company rises. For most employees, the options are a long term investment strategy. For that matter, must companies have a policy that several years must pass before an employee is fully vested and can exercise their options. Are you really going to play your option on a one time blip in the market?

I believe, employee stock options encourage long term thinking. It is a far superior means for preventing insider trades than employee stock ownership plans where employees actually have their funds at risk.

In theory, employee options should temper employees interest in trading their company stock. Smart investors diversify their portfolio. It is plain stupid to have your salary, options and investments all dependent on the same source. Smart companies that offer options should strongly discourage their employees from owning the stock. Of course, there are many Enron's out there that actively sell stock to employees. A company that has the best interests of its employees at heart would discourage stock ownership by employees.

don't expense them!! by Anonymous Coward · 2004-06-27 12:50 · Score: 2, Insightful

I have been investing in stocks for nearly 10 years. I have several books on accounting, I read all the financial data for the companies I own, and I even read FASB's and stuff like that from time to time.

After a while you learn that the numbers that GAAP gives you are pretty arbitrary. Conservative, yes, but still arbitrary. Many industries have their own "traditional" metrics that they report alongside GAAP, or in the "glossy pages" of the annual report. REIT's (real estate investment trusts, what I know the best) use FFO (funds from operations). Warren Buffet reports "pass-through" earnings for all his companies, even the ones he only owns a small portion of, even though GAAP says a holding company doesn't need to add in all minority interests. Etc.

The point is, I already "know" how to mentally adjust numbers for all this and create my own pro-forma results in my head. Reading these 10K's is not easy, they are complex and they bury stuff in the footnotes. But it's all there if you do your homework. Is it Microsoft's fault that CNBC reports the GAAP numbers? How about when a company takes a one-time charge and the numbers seem really bad, but the company is still in great shape?

The investors still have to study the financial statements. If you think a company is too complicated, don't invest! It doesn't make sense to throw more aribitrary junk into the financial statements. And options are not expenses, why treat them that way? Giving away something of value is not the same as spending money (hello, open source!).

I can see where Buffet is coming from.. this is the same guy who once said there should be a 100% short-term capital gains tax, just so people wouldn't churn the market so much. He's thinking that if stock options were expensed, companies would begin avoiding them, and it would create clearer, more transparent financial statements.

Yes, it would do that, but on the flip side options are a very useful compensation tool, and I don't think they are going to go away.

So, please, don't expense the options, just report them in the footnotes as usual. Please don't put more arbitrary non-cash numbers in the financial statements, they are confusing enough.

Michael's effot to turn /. into Salon? by Libertarian_Geek · 2004-06-27 13:26 · Score: 2, Insightful

I do think that at the very least, this is just outside the edge of being classified as news for nerds. Maybe news for opinionated libral nerds would encompass this story.
Before you consider this flamebait, consider what I'm saying carefully.

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www.fairtax.org

The proposed rules are stupid by Keeper · 2004-06-27 13:31 · Score: 2, Insightful

It doesn't give any useful information to investors.

Options should be expensed when they are exercised. Not before.

The figure listed isn't necessarily a bad thing, and would be useful to project the outstanding value of outstanding options the copmany currently has, but it shouldn't be treated as an expense because the figure is misleading and hides the true operating costs of the company.

Re:The Financial Account Standards Board disagrees by El+Volio · 2004-06-27 13:58 · Score: 2, Interesting

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.

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"You can never have too many elephants on your team."

The question is... by rice_burners_suck · 2004-06-27 14:52 · Score: 3, Interesting

My opinion on this issue is quite simple: If it will screw Microsoft over, do it. If it won't screw Microsoft over, or if it will be to their advantage, don't do it. Simple indeed.

So the question is, what's the most disadvantageous for Microsoft?

60% drop in earnings by khallow · 2004-06-27 15:41 · Score: 4, Interesting

I've argued in favor of expensing stock options in a number of places in this message, but this represents what I think is the true problem with the current accounting approach.

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.

Re:60% drop in earnings by Tod+DeBie · 2004-06-27 18:32 · Score: 2, Insightful

"According to Bear Stearns, there would be a 60% drop in profits if the new rule were imposed." Someone is going to have to explain that to me.
Today, the expense for options shows up if and when the options are exercised by the company either diluting the stock pool or buying back shares to compensate. Either way, this shows up in the financial statements. It just shows up at the point the options are exercised, as opposed to the current proposal to guess what their value might be and then stick that guess into the financial statements (and re-do the guesses every quarter).
The point is that we can either use real data (and get it when it happens), or we can use meaningless data earlier. It looks to me from the quote above that the guess produces a 60% error on average from reality.
I'd rather use real data.

Trying to Have it Both Ways by WaltFrench · 2004-06-27 17:35 · Score: 2, Informative

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
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 .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.

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.

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"Inquiring Minds Want to Know!"

this might work... by alizard · 2004-06-27 18:01 · Score: 2, Insightful

They probably shouldn't be expensed until after the company either goes public or hits a market cap threshold. At that point, there is generally some remote clue as to the actual value of the stock, as opposed to what the initial investors, founders, and new employees are praying that it's going to be.

For a mature company, say MS to issue big gobs of stock to employees without expensing them and keeping the no longer unknown value off the books is a trifle ridiculous. At this point, this is just another form of compensation and as such should show up on the books as an expense. A.Lizard

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Tech Public Policy stuff

How does crap like the above get modded up to +5? by Jewbird · 2004-06-27 18:11 · Score: 2, Interesting

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.

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For God doth know that in the day ye eat thereof, then your eyes shall be opened, and ye shall be as gods

Get a grip on reality by Anonymous Coward · 2004-06-27 19:14 · Score: 2, Informative

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.

Accountants, please answer this by Bob+Cat+-+NYMPHS · 2004-06-27 20:40 · Score: 2, Interesting

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?

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Re:careful with options, please! by gadget+junkie · 2004-06-27 20:50 · Score: 2, Interesting

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)

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"If a boss demands loyalty, give him integrity. But if he demands integrity, give him loyalty." (John Boyd, 1927-1997)

Options Acctg: Prvt. Start-ups vs. Public Cos. by DennisCDuring · 2004-06-28 01:13 · Score: 2, Informative

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

IBM will expense options for 2004 earnings by kence · 2004-06-28 01:30 · Score: 2, Informative

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.

Microsoft has been doing it for years.... by Anonymous Coward · 2004-06-28 02:07 · Score: 2, Insightful

http://www.billparish.com/msftfraudfacts.html

Employee stock options are mentioned in point #3:

3) Convincing Employees to Take Less Real Wages:
Microsoft aggressively markets stock options to new employees in an effort to take wage expenses off the books. They also know that they can pocket the exercise price employees will be required to pay to take ownership of the stock. What also seems clear is that Microsoft is still aggressively marketing its stock option program to new recruits. To quote an email received, "I am about to begin employment at Microsoft and the stock option was the selling factor. Does your article overall state that it will be bad for me and will fail me in my retirement planning?" Is Microsoft fulfilling its disclosure obligations to its own employees, especially those that have put their entire 401K balance in Microsoft stock? This explains how 22 percent of Microsoft's massive cash balance has actually come from its own employees in the form of them prepaying their own wages through stock option exercise prices.

6) Stock Option Accounting: It is important to note that any discussion of stock option accounting must address two completely different and independent situations. The first is to analyze the impact of options exercised and already retired and the second is to analyze the remaining options debt outstanding. This study focused on both whereas most media coverage only focuses on the remaining options debt outstanding.

Options Exercised and Retired: When stock options are exercised, the options are retired as the employee takes ownership of the stock. The value of these "retired" options should not be a subject of debate. Upon exercise, the options are valued at the market price of the stock less the exercise price and the employee pays W-2 taxes on this gain, even if the stock is not sold. The company then takes a tax deduction for wage expense for the same amount. What is surprising is that not a dime of this expense is charged to earnings at Microsoft, which they could voluntarily do. This amount alone for 1999 should exceed $9 billion even though net income is only $7.8 billion.

Remaining Options Debt Outstanding: The remaining unexercised stock option liability is a completely separate issue and a debt just as real as the current stock quote, especially if half of the options are currently vested and exercisable. We all know that stocks can be over and under valued yet the market gives us a price on any given day and that is the price. The Black Scholes and related footnote disclosure is a great mathematical model yet has become nothing but a Trojan Horse for plundering the retirement system. What the Treasury Department and Federal Reserve might concern itself with is that this debt, $60 billion at Microsoft, has no interest cost that hits the income statement and increases $800 million with each $1 increase in the stock price. Simply put, Microsoft is somewhat immune to Federal Reserve interest rate hikes, which explains why the stock is increasing as the Fed raises rates and continues creating a Long Term Capital like debt pyramid.

Those who have significant stock investments in Microsoft think they are protecting their investments by defending Microsoft, but in reality they are like the Enron employee who bought Enron stock while management was 'broadening' their investments. Microsoft owners/management have been disinvesting in Microsoft for years under the guise of 'broadening' their portfolio.

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Should Companies Expense Stock Options?

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