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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 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.
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.
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
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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Excerpting from this recent article about the issue:
[The FASB board is the federal advisory board that's hashing out what should be done about expensing stock options.]
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 ...
The fact that no one understands you doesn't mean you're an artist.
The REAL issue with whether options should be expensed or not is whether the diluted EPS captures the full effects of dilution through options issuance, or if there are hidden costs. There's a non-zero "option value" to the options (the choice not to exercise if the stock price drops), that is distinct from the "intrinsic value" (roughly equal to the strike price minus the current price). The argument is that this is presently not captured in the accounting regulations.
For more info on share dilution, check about.com's primer. There's also a section in there on common tricks companies use to hide dilution effects.
If you think Enron and Worldcom cooked their books, just wait until you see how the "expense" of stock options winds up being calculated.
They'll play with it, of course, but how can expensing the options at any positive value be worse than the status quo? Most companies currently take no hit whatsoever for issuing options; it seems much better to argue about whether the cost ought to be larger or smaller than to ignore the cost entirely.
It's just as bad as requiring businesses to value their "goodwill" and take an earnings hit when it "goes down".
"Goodwill" does not mean what you think it means. It's not the case that businesses estimate the dollar value of their reputations, as the word might seem to imply. It's a trick used to account for what happens when a company purchases another company. Suppose you want to buy my business, which consists of a factory and other physical assets, a large, loyal customer base, an excellent, widely-recognized brand and a bunch of great employees. Clearly, the employees, the brand and the customer base are all valuable to you, and are the real reason you want to buy my company. But the employees, great as they are, are an expense from an accounting point of view, and the customer base and the brand are irrelevant.
So, suppose you agree to pay me $100M for my company, and the factory and tangible assets are only worth $20M. That means your balance sheet will show a $100M debit and a $20M credit. On paper, your company just lost $80M by buying mine, even though everyone agrees that my company's future earning potential is well worth $80M, because of the above-mentioned factors. It would be inaccurate to show that the value of your company declined by $80M as a result of the purchase. Maybe the value went up, maybe it went down, but as far as anyone knows now, it was a fair price, meaning you got what you paid for, so you broke even, from an accounting point of view.
The solution is "goodwill". Your accountants will record a $100M debit to cash, a $20M credit to tangible assets and an $80M credit to "goodwill". If, a few years later, you determine that that division of your company is now worth only $60M (fair market value), because the market for its products declined, or you just didn't manage it well, then you will reduce the "goodwill" on the balance sheet accordingly and take that hit as an expense. Assuming the factory is still worth $20M, my "goodwill" is now worth $40M, so you'll apply a $40M expense, reflecting the actual decrease in value of your company.
I'm sure I've got this at least partially wrong, hopefully a real accountant will chime in, but that's the gist and it is a sensible approach to solving a real problem.
Note to ACs: I usually delete AC replies without reading them. If you want to talk to me, log in.
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.
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.