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Employee Stock Options Must be Treated as Expenses
currivan writes "In a move that's been in consideration for a long time, the Financial Accounting Standards Board (FASB) approved new rules requiring employee stock options to be treated as expenses for reporting purposes. One of the reasons so many tech companies have given options to IT/engineering workers is that until now, they haven't counted against profits in quarterly reports. If markets were truly efficient, this wouldn't make a difference, but in reality, the tech industry is strongly opposed to the rule, though it should please Warren Buffett."
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Can someone confirm how this really works? When options are granted, it is usually an option to buy a certain number of shares at today's market value. So on the day of the grant, the value is usually always 0.
Let's say an option is granted to buy N shares and a year from the date of the grant, the stock is up by 10 points - then the value is then 10 x N. So the company now needs to subtract 10 x N from its earnings for the fiscal year during which the stock was up by 10 points? Then next year it goes up again and the company adjusts earnings again? Ad infinitum?
OR does the company just make a speculation, something like "we think the stock will go up by 10 points this year, so lets just subtract 10 x N from earnings". But what about the value 10 years from now?
What happens with taxes? It is advantageous for a company not to ever show any profits, this seems like a simple way to reduce your taxable income as far as the IRS is concerned. Most corporations don't pay any taxes anyway, but now this just got easier: "Let's grant everyone a bunch of options that we deem are worth 10 bazillion"?
Lastly, I don't see how this rule will affect anything at all since more likely than not companies will just be publishing two numbers - earnings with stock option adjustment and without. Kinda like EBDTA.
IANAA (accountant) but I would think this move might have some massive tax implications. Would this force companies to pay more in payroll taxes? Could it allow them to pay less?
Someone with more knowledge on this please reply. thanks!
There's a Mercedes gap too. I want one and can't afford one, but it's not government's job to do anything about it.
Stock options don't require the company to spend any of its revenue. So giving them reduces profit on the books, while it doesn't affect the profit of which the stock represents a share. How does this make sense at all?
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For all of the privately held companies who compete against publicly traded companies who pay out stock options like Monopoly money...this rocks.
The surest way you know a company knows what its doing is if it's turning a profit. This should take one more accounting trick away from the pretenders out there.
I haven't received any stock options that ended up being worth a crap since the 1990's. Who cares anymore. Be a contractor and make more money then the employees. Then you can buy your own stock!
When it's granted the option has an intrinsic value of zero, but it's *extrinsic* value is more. Let's say the stock price S is 100, and the option exercise price K is 100 too. You could exercise the option today and make a profit of S-K = 0. That's the intrinsic.
In a year's time, the stock could be worth more than K, in which case the option's intrinsic value will be S-K, or it could be worth less, in which case the intrinsic value will be 0.
The extrinsic value of the option is what it's worth in the market, and presumably what it will be charged at in the accounts. It's calculated by taking the expected intrinsic value at expiry.
For our example, let's imaging there's a 25% change of the stock being worth each of 70, 90, 110 or 130 in on year's time (we'll assume it can't take any other value). The expected value of the stock in a year's time is 100 just as it is now:
E[S] = 0.25 x (70 + 90 + 110 + 130)
= 100
However, the expected intrinsic is...
E[max(S-K,0)] = 0.25 x (0 + 0 + 10 + 30)
= 10
So the value of the option is 10.
Of course, there's more to it than that. The distribution of possible stock prices is continuous. We've also ignored the fact that I'd a dollar today is worth more than a dollar in a year's time. There are theories on how to value these things...
This change would have occurred 10 years ago if Congress hadn't interfered on behalf of companies trying to hide their largesse from shareholders. The rest of the world is in the process of implementing a similar accounting treatment of options. The US would have looked idiotic to have delayed this further.
The people who lose in this scheme are the purchasers of stock at full price. The cash flow out of the company dilutes the value of the company, making each share of stock worth (a tiny bit) less. Some people pay full price, others (insiders) reap a benefit at a discount.
The requirement that these discounts are accounted as expenses, puts a dollar amount on them. Thus, someone (and outsider) looking at the company financial statements gets a clearer picture of where the money is going. They get to make a more informed choice.
Its a good thing.
"The most sensible request of government we make is not, "Do something!" But "Quit it!"
My guess is that they will most likely use The Black-Scholes Option pricing model with a few refinements.
HERE
In case you haven't heard, Microsoft (MSFT) has been deeply unprofitable since 1996, when it began to rely on holes in the GAAP accounting standards that allowed it to report historic profits in its NASDAQ filings. Large fund managers bought into it to the tune of hundreds of billions of dollars, making MS at its peak ($700B) which for comparison made it the largest component of the S&P 500, the equivalent of the 16th largest country or ~1.5% of the GDP of Earth. Though billed (no pun intended) as a success story, when the bubble burst investors lost billions.
Who cares? The biggest funds involved were pension funds of large social programs across the US, e.g. the California Teachers Union, who automatically invest in S&P components at rates proportional to the components' value. MS paid for its bottom line with those peoples' money, so much so that pensioners are majority owners of MS today. Too bad for them that the bottom fell out of MS stock and their savings are worthless. But it did help create two of the richest personal accounts on Earth.
You could argue that this was all legal and that they won the king of the hill prize. Perhaps. But is it ethical to block GAAP reforms via corporate shills in Congress (e.g. Joe Lieberman) so your huge losses won't be exposed? Enron execs are being hung out to dry for being only slightly on the other side of that thin line in the sand. No, it's likely MS knew what it was up to. As Bill Parish, who broke the story, tells:
"Microsoft's perspective is best reflected by Bob Herbold, Chief Operating Officer, to whom the CFO reports. Bob very sincerely [explained the situation to Gates], "Bill, everyone is doing it.""
This is a great vindication for Bill Parish, and another step towards reigning in widespread corrupt accounting practices. http://freality.org/~pablo/essays/microsoft.htmlThe problem with this proposal is that it attempts to fix dodgy accounting by introducing more dodgy accounting.
Stock options are not granted by the company. They are granted by the shareholders. Every stock option grant I recieved, even from a small, no longer here startup, was granted by the board of directors, not the executives of the company.
The shareholders of the company basically offered me a deal that if the stock price of the company is greater than the strike price, then they would allow me to purchase shares of the company at some strike price. Essentially the shareholders of the company incurred a future liability equal to the number of shares times the difference between the actual price of the stock and the strike price.
HOWEVER, rather than show this liability on the books of their investment business, investors shift the potential future cost of the options back to the company. Remember a corporation is a legal entity, so what we have is a shift of liability from one legal entity, the shareholders or venture capital firm, to another legal entity, the corporation.
Interestingly enough this is exactly how Enron worked. Enron created a large number of shell corporations and made Enron's books look better by shifting income to the parent corporation and shifting liabilities to the subsidiaries. This is a classic technique in fradulant business practices, namely moving liabilities off of the books of one corporation. But I digress...
Back to the issue at hand. Institutional investors, rightly, are annoyed that these future liabilities aren't accounted for properly. Unfortunately, their mechanism, is flawed. Ideally, the liability of future options would be shown directly on the books of the owners of the company, not on the company itself. The investors aren't going to do that as it makes their investment business financials look bad.
Given that the shareholders shift the burdon of funding exercised options to the company, then this liability should be treated as a future debt, not like a current expense. When a company takes a loan, they expense the payments as they are made, not the entire amount of the loan up front.
Stock options are not an expense. They are a debt instrument, like a loan and should be accounted for as a liability on the balance sheet and expensed when the options are excercised and paid off. At that point, you remove the options from the liability side of the balance sheet.
It was Indiana. The reference you cite is talking about a hoax; Indiana actually did present a bill.
have much in common, particularly the part about options expiring at zero value. It's interesting that the FASB considers this in the same light.
Of course, we all know who gets rich from the lottery, don't we? I never understood people who accepted company stock as bonuses, payment, etc. From where I stand, when the company starts handing out shares instead of cash, it's time to start looking around.
*whup* "Get along, little electrons. Heeyah!"
If so, then I'm not interested in us peasants, 90% of whom get little-to-no stocks, but I want to know that Bill the Gates, and Kenny-boy Lay, and Eisner, and all the rest of the CEOs with tens of *millions* in stock options have to be expensed.
Gee, what might happen to all that money if it didn't go to CEOs? Maybe it would get wasted on utterly frivilous things, like better employee salries and benfits, and maybe even capital plant development!
Nahhh, never happen, ship it all off to India.
mark
Maybe we can relate this to something that is happening in Mexico recently. Instead of being given a share, employees are given other "comodities" (i.e. food/expense tickets, etc) that are NOT reported as the worker's salary. This means the reported salary is much lower than it actually is.
When the employee retires, they only give him a compensation regarding his REPORTED income, not the real one. This way the company saves millions by giving its employees money in a different denomination.
I *THINK* that somehow, this is what happens with stock shares... that the company is saving taxes / other payments because they give their employees other kind of money, and not cash. That's why the shares must be reported now. Obviously, companies don't like it because they see lost profit in it.
Someone correct me if I'm wrong, please.
[I was a quant working at a major bank until leaving this year]
Putting a value on those options is itself a matter of some contention. Basically, employee stock options (ESO) nearly always have a strike K bigger than the current stock price S when they are granted. The value of the option lies in the fact that it is reasonably likely that at some later date, K>S.
So, a foolish measure of value would be intrinsic value: i.e. MAX(0, S-K). There is a formula called the Black-Scholes formula used for pricing options with only one allowable exercise date, and no other special features. That formula is quite inappropriate for pricing ESO, since ESO come with lots of other quirks, including vesting periods, stock holding periods, employee attrition, and (not least) lengthy time intervals in which they are exercisable.
Of course, to accountants even the BS formula is exotic. Rather than using a proper model (hinted at in FASB 123 with the moniker "binomial model") to price the options, accountants prefer to use BS, and then "adjust" the results as they see fit to account for the various features. The results of this are better than just using intrinsic value of course, but not by much.
I developed a model for the bank to use in pricing its ESO. It was reasonably correct, in the sense that it used the traditional approach of a trinomial tree to model the stochastic process followed by the stock price, along with code to account for the various quirks of our options. It still had manipulable inputs, such as volatility, but at least accountants would have to have justified their values.
Of course, internal politics killed the model in favor of the BS formula, and arbitrary accountant's adjustments. If that's what happened in a major bank, with the generally stated goal to transparently publish numbers, and with guys like me around to develop models like that...well, how much are you going to be able to trust the option expenses published by other companies?
I hope that FASB fixes this, and deprecates the use of the BS formula in inappropriate contexts.
Some other accounting favorites...
Accounting vs. Math/Statistics
Accounting Variance = Mathematical Difference
Accounting Volatility = Mathematical Variance
Whatever accounting is...it is not math, I am convinced.
Mod parent up, Black-Scholes is the most common way to value options. It uses expected volatility in the stock price together with the time horizion until the option expires to calculate a value. A lot of trading sites (etrade, anyway) will calculate option values for you using this model.
http://en.wikipedia.org/wiki/Black_Scholes