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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."
As all the geeks on /. try to figure out what this means.
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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.
Yes. The opportunity is worth something all by itself. A stock option grant represents a potential dilution of ownership for current share holders. Think of it this way. Company A has 1 million shares of which you own 100K. You are entitled to a 10% share of the company's profits. The management of the company, in an effort to attract talent, grants 500K more shares. You're ownership now could fall as low as 6.67%. That potential dilution is a real expense to you. Even if it never comes to pass.
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.htmlIAAA (I am an accountant), and essentially you keep two sets of books, one for accounting purposes and one for tax purposes. Tax accounting is based on cash flows in and out of the company. Since this rule change doesn't effect these cash flows, there shouldn't be any tax implications to this change.
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Accounting isn't about "real cash" and hasn't been for a while. What you say is literally true, but in accounting terms, there was a real change to your assets, assuming of course that the $10 and $6 were commitments and not just some Slashdot guy saying something for a demonstration (because then the assets are $0 and $0, and no change of any kind takes place) :-)
I've had to learn some accounting to implement accounting systems, and the disconnection from real money is on the one hand powerful; it gives a better view of the functioning of the business than the bottom line "how much did we make or lose?" But it is, as usual with power, correspondingly more dangerous, if you start believing the numbers are too real; the phrase "bottom line" has entered our vernacular for a reason.
In double-entry bookkeeping, you change in promise would cause a debit for us (and the corresponding credit for you), causing a drop in our assets of $4. Our cash wouldn't budge an inch, but the accounting changes.
It's worth looking into (google "double-entry bookkeeping"); I find it similar in some ways to physics, in the way that it is sort of based on a "conservation of assets & liabilities" law. Treated properly it will improve your understanding of money. Misunderstood and it will make it worse.
Under accrual-based accounting, options are always recorded at cost, so they always have value (par value or stated value plus or minus paid-in capital). Under accrual based-accounting, no buying or selling has to occur for it to be recorgnized and recorded. A mere "promise" satisfies the principle of materiality required to record the event.
In other words, it sounds as if stock options, which weren't liabilities in the past, should now be recorded as liabilities on the accounting period in which they are given. This is important because liabilities that represent expenses are significant to judging the state of the corporation even when they yet haven't actually been expensed yet.
Per FASB guidelines, all corporate accounting in the United States has to be accrual-based. The only entities that still use cash-based accounting are government entitites. With the new ruling, pretty much everyone but the government has to change the way in which stock options are recorded. So your point, though intuitive when thinking in cash terms, is largely inapplicable to everyone but the government.
[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.