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The Coming Expensing of Employee Stock Options

Posted by Hemos on from the big-changes-coming-down dept.

An anonymous reader writes "This accounting change will reverberate loudly throughout geekdom. "Users of financial statements...expressed to the FASB their concerns that (the current handling of stock options) results in financial statements that do not faithfully represent the economic transactions affecting the issuer, namely, the receipt and consumption of employee services in exchange for equity instruments. Financial statements that do not faithfully represent those economic transactions can distort the issuer's reported financial condition and results of operations, which can lead to the inappropriate allocation of resources in the capital markets." Taken from FASB Statement of Financial Accounting Standards No. 123 (Dec 2004). A FAQ has been published as well." Yes; the data is from 12/16/04, but this will be a huge change in how tech companies work.

29 of 222 comments (clear)

  1. Stock options? by Dancin_Santa · · Score: 5, Informative

    That's so 1998, man.

    Actually, with the tech implosion back in 2001, this affects technology companies less than we would expect. It was put in place to catch companies that were writing off massive amounts of tax through the issuance of options. However, with fewer companies doling them out, and employees less enthused about receiving them, this new regulation affects the old bricks and mortar companies more than those in the tech sector.

    1. Re:Stock options? by eyeball · · Score: 3, Interesting

      Actually, with the tech implosion back in 2001, this affects technology companies less than we would expect.

      Dot-com era tech companies aren't the only ones that used stock options as incentives. Our fortune 500 company of over 200,000 employees has traditionally distributed stock options to its management employees as part of a bonus package. This year they won't, but it remains to be seen if we'll get cash, straight-out stock, or a screw-job.

      --

      _______
      2B1ASK1
    2. Re:Stock options? by Razzak · · Score: 2, Interesting

      It was put in place to catch companies that were writing off massive amounts of tax through the issuance of options.

      Ehh, sort of. You don't "write off" options. You don't pay anything for options, the shareholders end up eating the cost, so there's nothing to write off. Salary, under $2million, is tax deductible so you would write that off. This was imposed so that people could more easily view a company's true earnings, factoring in work done by employees that was compensated by the shareholders (via options). Here's a quick ridiculously simplified example.

      Company A makes $10 million in revenue and has $5million in salaries, blah blah blah has a net income of $5 million this year.

      Company B makes $10 million in revenue and has $2.5million in salaries, thus having a net income of $7.5million. They also granted $5million in options@$3 which were sold @$3.5, resulting in $2.5million dollars of compensation for companies paid (basically) by the shareholders via the stock price.

      With the new rules, companies will be forced to estimate the value of options on the date of grant. Therefore, Company B will have a net income of somewhere around $6million to $7million depending on what the estimated value of those stock options are.

      To answer the question: "Why don't they just wait to see exactly how much the options were exercised at and account for the actual cost of the options?"

      Three reasons.

      1) People claim it's unfair to companies who perform well, as they'll have higher stock option expenses. More importantly is point 2).

      2) It's a serious pain to go back through the last 10 years of accounting statements every quarter and re-do all 10 years. How would you like it if you were following a company and every quarter you had to re-evaluate all 10 years of that. It's just not feasible.

      3) When you estimate the grant of options, it's what those options were worth at the time (or their "fair market value"). If your stock was $1 and it went up to $100, it's not fair for the company to expense all $99 of that increase, because no one knew it was going to do that.

      There are two drawbacks to expensing.

      1) Companies whose stock drops and sees no expense from options will still have to expense their estimated value when they issued them. (Which is fair, because if their stock skyrockets they still only expense the estimated value).

      2) Depending on how expensing is set up, there may be a lot of room for manipulation of the numbers. If companies have too much control over the assumptions that go into expensing formulas, the estimates may be overly optimistic and misleading. For example, on a 10 year option, if you estimate that most will exercise that option within 2 years, that seriously reduces the values of those options. There is a difference between Binomial model and the Black-Scholes model, which I won't go into here. But FASB needs to seriously address this issue.

      razzakjallow@yahoo.com

  2. Eh. by Anonymous Coward · · Score: 3, Insightful

    Am I the only one who has no idea what the hell that summary just said?

    Can someone please translate it into plain english for those of us who either A) have never had stock options or B) are just too dumb (me perhaps) to decipher what was said?

    1. Re:Eh. by acvh · · Score: 4, Informative

      In the past, companies could issue stock options to employees essentially at no cost to themselves. This would tend to understate employment costs, making them look more profitable than they really were. In addition, the exercise of these options would dilute the value of the stock held by shareholders.

      Now they have to expense them using "fair value", which is what an investor would currently pay for an equivalent option. This, in theory, will more effectively represent employment costs.

    2. Re:Eh. by bulkmailforyou · · Score: 4, Informative
      Bottom line is: all employess will get less stock options than before. Since they are now expensed, it affects the companies bottom line. Options will now be given less frequently, in smaller amounts or even no longer at all. This all depends on what the company wants, but this gives no reason to increase options.

      If you didnt get stock options before, you still get none.

      Investors are affected, since over time the talent leaves a company and the company loses innovation and just maintains their current product.

      Accountants in find new creative ways to fake out the investors. This still has no real advantage

      Take my post with a grain of salt - as you can tell I am against the practice.

    3. Re:Eh. by EyeSavant · · Score: 5, Informative

      Yeah all you used to have to do is make a note in your accounts about the number of shares you have issued. I.e. do nothing.

      It also allowed a fun little scam in that the tax man allowed you to expense your stock options and subtract it from your profits before paying tax. This is why MS and others spent several years not paying tax. What they were actually doing is NOT MAKING MONEY. All their profits were going straight to the employees, and noone noticed as it was coming back in as they were issuing extra shares. A lot of MS' cash pile came from selling shares.

      Basically there were two very different ways of acocunting for the same thing. If you pay your employees in cash, then issue extra shares to have the money to pay for it, it comes off your bottom line as it should. But give them cheap shares instead and it doesn't. The end result is the same, x extra shares issued, y extra money to empoyees, but one means you are in trouble, the other is a sign of a really healthy company. Until now. It is a good change.

    4. Re:Eh. by jj_johny · · Score: 3, Informative
      I really enjoy the folks out there that talk about the expensing as though its going to change everything. The reality was the stock options were used as employee comp but not counted as such. And I don't know of too many geeks who really understood the value of them when they got them. So when I got a boatload of options for joining a little company that was going to hit it big, I thought about it being a 10% bonus or something like that. It turned out that over the 5 1/2 years that I worked there I was paid (yes it said so on my W-2) 8 times more in exercised stock options than in my salary. (Granted my salary did not keep pace since I was in the money in my options.)

      Anyway, how does it make sense that a company paid me 7 figures for a couple of years when I was making high 5 figures. They had to be expensed, it was a crazy situation where your compensation really revolved around luck, when you got hired, what company you went to work for and how many options they gave you.

    5. Re:Eh. by RetiredMidn · · Score: 2, Interesting
      In the past, companies could issue stock options to employees essentially at no cost to themselves. This would tend to understate employment costs, making them look more profitable than they really were. In addition, the exercise of these options would dilute the value of the stock held by shareholders.

      Except that a stock option is not really a "cost"; it does not deplete the company's assets to issue them. If any dilution occurs, it is when shares are issued and/or set aside for the purpose of issuing stock options, and, as I understand it, this is something the shareholders have to explicitly approve and is therefore duly noted in the company's financial records.

      Now they have to expense them using "fair value", which is what an investor would currently pay for an equivalent option. This, in theory, will more effectively represent employment costs.

      My only problem with this is that, as the FAQ points out, there is not really an exact equivalent available to the general investor. Which means the calculation of the "value" of an option is something of a fiction, which is not accounting as I thought I understood it (and I never thought I did...).

      I would have considered it more accurate to regulate how shares that are set aside for options are accounted for. If I'm worried about options, I would be able to figure out how vulnerable the stock price is to sudden shifts in ownership due to option exercises, just like I can figure that out based on company reporting of large blocks of outright ownership.

    6. Re:Eh. by EyeSavant · · Score: 4, Informative

      Except that a stock option is not really a "cost"; it does not deplete the company's assets to issue them. If any dilution occurs, it is when shares are issued and/or set aside for the purpose of issuing stock options

      Not true. At the risk of repeating myself from my other post. Compare two cases. Company share price is $100 dollars a share

      Case 1 : Company issues 100 extra shares at $100 (total $10,000), gives $5,000 cash bonus to employees, keeps other $5,000

      Case 2 : Company gives 100 share options to employee with a strike price of $50. Employee pays $5,000, then sells shares for $10,000

      In both cases 100 extra shares are issued, the company gets $5,000 and the employee gets $5,000. Yet the accounting treatment is completely different. In case 1 they have to make a note that they have issed 100 new shares, and take a hit of $5,000 additional expenses. Under the previous rules all they had to do was make a note that they had issued 100 extra shares. The company IS losing money as they are not getting full value for the extra shares issued. The real loser are the other share holders. with the diluted value of their holding. Say a company has 100 shares outstanding share price $100. The company is worth $10,000. I own 10 shares, value $1,000. Now they give the share options above out. The company is now worth $15,000, the value before plus the $5,000 extra cash they made. But I have only 5% of the company, not the 10% I had before. So my shareholding is now only worth $750. Clearly in the real world the numbers are different, and it can take a while for the market value to converge with the "real" value, but the principle applies. Giving out share options is an expense, they should be treated as such. Clearly accuratly costing these things is damn hard (there are rather a lot of books on how much share options should be worth). But it is only real money going out when the option is exercised so it *should* all come out in the wash. There are lots of things that are hard to put a price on in accounting, where they just guess until they know the real number, so there is no real problem with that.

    7. Re:Eh. by Anonymous Coward · · Score: 2, Interesting

      People have been warning anyone who would listen for several years, but most were on the take and their greed wouldn't let them see the true cost of this graft. Bill Parish, and accountant who first made public noise about this, and has been savaged by Microsoft's PR machine and sychophants every since, details the scam here:

      http://www.billparish.com/msftfraudfacts.html
      o r here:
      http://www.usagold.com/gildedopinion/micros oftfrau d.html

      "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."

      This is only one aspect of the total scam which that article details.

  3. Who Gets Stock Options? by NardofDoom · · Score: 4, Insightful

    Hell, I'd just like to be paid overtime.

    --
    You have two hands and one brain, so always code twice as much as you think!
  4. Just work a 40-hour week by Anonymous Coward · · Score: 2, Insightful
    No pay, no work.

    If you're good enough, it'll work.

  5. Does it mean LESS stock options, or not? by joelethan · · Score: 2, Interesting
    If stock options are accounted for as expenses, then they are less "attractive" as rewards for staff - prima facie.

    But will it really change the packages on offer? I guess that everyone from CEO down wants to retain stock options. They will just look more expensive to investers i.e. they will get a better view of a firm's financial behavior.

    The relevance to slashdotters, is of course that tech companies have had the growth profile and preferred this "cool" way of rewarding directors and staff.

    /joelethan
    -- In Sri Lanka they aren't worrying about their STOCK OPTIONS being underwater. --

  6. Mostly implemented by confusion · · Score: 2, Interesting
    Most prudent CFO's have already implemented this. From what I have seen, stock options have been relegated back to start-ups, executive compensation packages, and in small amounts, performance & incentive bonuses for those who are the "top performers".

    Jerry
    http://www.syslog.org/

  7. Why this is important.. by Deal-a-Neil · · Score: 4, Insightful

    This is important because companies that do not report this method of compensation (stock options) have inflated reported financials because options were not properly accounted for on the statements. So, what does that mean? Analysts and investors did not have full disclosure as to how future stock options being exercised would really affect the company in the long (or sometimes short) term.

    This will not only change the way that tech companies operate and report, but other huge publically traded corporations. When a company lures a big name CEO/CFO, and promises hundreds of thousands or millions of stock options to be exercised at a later date, that dillution of equity (even though in the future) was not being properly declared on the financial statements. Now that the FASB (financial account standards board) has made this recommendation/ruling, companies must comply.

    This is what one might call "truth in financial reporting", and I'm very glad to see that this has passed. This has been a very long existing loophole that large companies have used to the detriment of our investment community, and the general public (i.e. our domestic economy) as a whole. Don't be blindsided by the rhetoric that only "tech companies" will be affected by this -- there were a LOT of big corporate powers that did not want to see FASB rule, and whenever you have that, you always have to wonder what their reasons are. I encourage you to read the FAQ, and read any news articles you can regarding this ruling. I think you'll agree this is a very positive thing.

    1. Re:Why this is important.. by kevinT · · Score: 2, Interesting

      Because it means that MICROSOFT won't be as profitable as before.

      Microsoft has fought this since it was first suggested. Some reports put Microsoft at a loss instead of profit for several years because they (Microsoft) were able to hide employee expenses in the stock options.

      It remains to be seen if this rule change will have much of an affect outside of reducing stock options more than the dotcom bubble burst did.

    2. Re:Why this is important.. by NotWallaceStevens · · Score: 2, Interesting

      On the other hand, this calls something an "expense" which isn't an expense except in a very abstract accounting sense, making earnings statements even more difficult to understand. Options are incentives which carry risk. This change undercuts their incentive value from the company's perspective, and ignores the risk (that if it really is an instrument in exchange for my services, then mostly I get screwed in that deal, based on our collective experience with options over the last ten years).

  8. "Yes; the data is from 12/16/04" by Anonymous Coward · · Score: 2, Funny

    How about "Yes, this is a re-post from last week's news?"

  9. Stock Option for Dummies by Anonymous Coward · · Score: 2, Informative

    A stock option is a contract that lets you buy a share of stock after some point in the future at a specified price. Example, a Google employee might get paid an option to purchase Google at $50 / share exactly three years from today.

    Three years later, when Google sells for $100 / share and you cash in your option, Google will pay the difference b/t the share price and the option price (in this example $50). This is an expense which is tax deductible. Such a deduction creates a GAIN. The gain can be classified as income from continueing operations .... very misleading.

    Also misleading is that a company can employ a bunch of people without incurring the usual payroll costs associated with employing people. Therefore, sales should rise, but costs of goods sold does not rise. This creates a misleading impression of profitability. However, the market will probably catch this and lower the value of the stock. And this can happen long before your option has reached its maturity.

    YOU DO NOT HAVE TO ACCEPT OPTIONS IN LIEU OF CASH. This is a decision each employee makes. You can, in theory, accept a lower pay of pure cash instead of a "higher" pay composed of stock options.

    Going back to the Google example, if three years from now Google traded at or below $50 / share, your option would be worthless and you would have nothing. That is why you might want to consider getting paid in cash VS. getting paid in options.

  10. Here you go: by Proaxiom · · Score: 4, Insightful
    Faithful translation:
    [Stock options result] in financial statements that do not faithfully represent the economic transactions affecting the issuer, namely, the receipt and consumption of employee services in exchange for equity instruments...

    Stock options amount to the company giving money to employees...

    ...Financial statements that do not faithfully represent those economic transactions can distort the issuer's reported financial condition and results of operations...

    ...without showing up on the company's books, making them look a little rosier than they really are...

    ...which can lead to the inappropriate allocation of resources in the capital markets.

    ...thus inflating the stock price and ripping off investors.

  11. Re:16th month? by Anonymous Coward · · Score: 2, Insightful

    Nah, not funny. Bitter and cynical.

    You clowns have to realise some day how totally screwed up a nn/nn/nn date format is when there is no universally accepted positional meaning.

    When Slashdot converts to ISO standard, I'll be happy.

  12. Dupe! by yopie · · Score: 2, Informative

    Yes; the data is from 12/16/04, but this will be a huge change in how tech companies work.

    It was mentioned in Slasdot on 12/17/04

  13. Hmmm... by devaldez · · Score: 3, Interesting

    Couple of corrections to the statements already made:
    1. It is not really possible to properly account for option grants vis a vis cash vaule because: a. options are a hedge AND b. options may not be cashed out (employee leaves/dies, stock is underwater)
    2. If 1 is true, then you get an equally distorted view AFTER this decision as before

    The argument that investors will have a better idea of the business as a result of this is not really accurate, either. After all, institutional investors already follow option grants, so this isn't hidden. If you don't follow this kind of data for any company you invest in, you're simply willfully ignorant.

    --
    "... but you can love completely without complete understanding." - Norman Maclean, "A River Runs Through It"
    1. Re:Hmmm... by ancientreader · · Score: 2, Informative

      Options are a hedge only if you are exposed to a pre-existing risk to rises in the stock price. It's hard to argue that any employee is exposed to a risk based on the stock price *rising*.

      Stock options without the pre-existing risk are speculative securities, just like stock or any other financial instrument. Employees earn income from stock options; hence, the company should record expense.

      While it's true that options may not be cashed out, the accounting standard allows for companies to adjust the expense based on changes in expected redemption rates due to the factors you list (employee attrition or stock price behavior).

      Accounting records anything with cash implications to companies. Options have such implications, and the presentation in income underscores this.

  14. Double accounting by bhurt · · Score: 3, Insightful

    This change will make stock options for anyone except the top most layers of management a thing of the past. You see, stock options are already expensed. The main measure of the value of a company is the Earnings Per Share, or EPS. This is the ratio of the total earnings of the company divided by the number of outstanding shares. Increase the number of shares, and what happens? The EPS drops. But now, if you issue stock options, you get hit twice. You get hit once by falling EPS due to the increased number of shares, and a second time as you have to decrease your earnings by an amount equal to the value of the stock option grant.

    The problem with stock options were the immediate grants. The idea behind stock options was to give the people in the company- not just the upper level management, but everyone- a stake in the company. A stake in the long term prospects of the growth- especially if the options you're granted now can't be exercised for five years. All of a sudden not only are you less likely to quit (and lose those options!), you're more concerned about where the company will be five years from now.

    The problem is with the CEOs getting multimillion dollar stock grants, on pennies on the dollar, effective immediately. This encourages to pump up next quarter's numbers by any means, hook or crook, so they can dump their stock. And to heck with where the company will be a year, let alone five years from now.

    But hey- given a chance to throw the baby out but keep the bathwater, would we pass up the chance?

    Brian

  15. keep screwing the little guy by oliphaunt · · Score: 3, Interesting
    The reality was the stock options were used as employee comp but not counted as such [...] it was a crazy situation where your compensation really revolved around luck, when you got hired, what company you went to work for and how many options they gave you.

    that's kind of the point. This rule, just like every other rule made under the Bush administration, is about screwing the little guy at the expense of (a) large corporations, (b) financial institutions, or (c) extremely wealthy individuals. If you go to work for a very early-stage company, and you are one of the first, say, 20 employees, you are really taking a risk- becuase the odds are that your tiny company just won't be around in 5 years. If you have a two kids, a mortgage and a car payment, how do you think it would impact your life if the company you work for suddenly couldn't make payroll? That's right, even with six months' savings in the bank (which you don't have) and a $10k limit on your gold card (of which you've already used $7k), you're going to be scrambling to find work. If I'm going to risk my livelihood for a dream, I expect to be rewarded handsomely.

    But a small company can't afford to pay you more in cash than a company like Cisco or Oracle, so that small company needed a way to reward quality employees for hard work and loyalty. That's what stock option grants at startups were about- the company rewards its employees for taking a risk, but is legally still solvent. And yes- it does revolve around luck, and when you got in- becuase if you join a company as the 100th employee or the 1,000th employee, it should be clear that you're making a much safer bet than the 10th employee was when she joined. High risk, high reward.

    Under the new rules, there's no easy way to reward early-stage employees for their risk-taking except to pay them more cash. And until the company is doing well financially, an employer can't afford to do that. Catch-22.

    This rule change will make no difference to CEOs of Fortune 500 companies, becuase they'll still get paid $lots. It won't change the risk involved for institutional investing, so the i-bankers and vc's will still have the same issues to worry about. If anything, it will make the i-banker's job easier, becuase there is one less number they have to add to the financial statements if the reporting company is putting it in there for them already. It will slow down the progress of startup companies with disruptive technologies, becuase it will be harder for them to motivate quality people to leave their current employers. It's a minor accounting change for a Fortune-500 company, and death knell for the way that startups recruit talent... which is probably music to the ears of those F500 companies who can now pay their regular employees LESS because they don't have to worry about as much competition for their talent.

    It sounds like you were the beneficiary (in spades) of the old system- you of all people should recognize the upside! The only real impact this rule change will have is to make it more difficult for very early stage startups to attract and retain quality employees- which is great for everyone, except entrepreneurs, their early-stage startup companies, and their employees...

    --




    Humpty Dumpty was pushed.
  16. Re:Not a scam. by nojomofo · · Score: 3, Informative

    Why it's a scam is that they didn't have to report it as an expense to their shareholders. So while they were telling the IRS that they didn't make money, they were telling their investors that the stock options were free, and that they were making money hand-over-fist.

  17. Misunderstanding of tax brackets by dinodriver · · Score: 2, Informative

    I think your post shows a misunderstanding of how tax brackets work. There is no benefit to "dropping down to a lower tax bracket." It sounds like you assume that if you are just into a higher bracket that you pay that rate on all your income. This is not true. You would pay that rate on just the amount of income that puts you over the limit into that bracket.

    For example, $70k is in the 25% bracket. $80k would be in the 28% bracket. One would only pay 28% on that last $10k and then pay 25% on about $10k and then pay 15% on about $40k and then nothing below that.

    Using stock losses to increase deductions and save taxes is a good idea that may work for some people. But it's not because it drops them down to a lower tax bracket.