Accounting in the new Market

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For my sake, let’s begin with some basic questions

What are stock options? A stock option is a warrant (certificates entitling the holder to acquire shares of stock at a certain price within a stated period) which gives selected employees the option to purchase common stock at a given price over an extended period of time. 1

Why do companies give employees stock options? Stock option plans are used to pay and motivate employees. They are very popular because they meet the objectives of an effective compensation program. 1

What is an effective compensation program? It is one that (1) MOTIVATES EMPLOYEES TO HIGH LEVELS OF PERFORMANCE, () HELPS RETAIN EXECUTIVES AND ALLOW FOR RECRUITMENT OF NEW TALENT, () BASES COMPENSATION ON EMPLOYEE AND COMPANY PERFORMANCE, (4) MAXIMIZES THE EMPLOYEE’S AFTER-TAX BENEFIT AND MINIMIZES THE EMPLOYEE’S AFTER-TAX COST, AND (5) USES PERFORMANCE CRITERIA OVER WHICH THE EMPLOYEE HAS CONTROL. 1




How do stock options specifically meet the objectives of an effective compensation program? Since compensation is directly related to performance of the company’s stock in the long run, employees are motivated to work hard and make the company as successful as possible.

Aren’t options already expensed in company financial statements? Under the intrinsic value method used by most companies, options are computed for inclusion as compensation expense. The problem is most options are reported at zero (discussed under calculating the expense section), implying they have no value and, therefore, no effect on net income. The debate arises from the FASB’s push to use the fair value method, which will assign a definite cost to the use of options as compensation expense. This will, in effect, adjust net income based on the expense. When we read about the push to expense options, we are really reading about the push to switch to the fair value method. From this point on, we will assume ‘expensing’ in the context of this paper actually refers to using the fair value method to expense options.

Why all the fuss over “expensing”? The bottom line is The bottom line! Expensing causes lower reported earnings, which in turn, causes lower earnings per share and, ultimately, lower stock price. The employees holding options want the stock price to be at maximum value when they exercise (cash in) those options.

The ‘pros’ of ‘expensing’ stock options

I. Accurate financial information

Stock options are designed to align employee and shareholder interests while providing everyday workers with a stake in the system. Unfortunately, stock options have recently been used to disguise costs, provide excessive rewards to people already excessively rewarded, and give CEO’s a reason to play games with earnings. In a post-Enron, World-Com, and dot-com investment environment, there is a demand for accurate and reliable financial information. Investors are looking for useful information that can help them make good financial decisions. By expensing stock options, we are providing an accurate financial picture of employee compensation expense. Although the option grants are currently disclosed in the footnotes to financial statements, they dont affect reported earnings when they are issued or when they vest. As a result, the current accounting treatment of options leads to higher reported earnings, with the negative impact on earnings arriving years later when the options are exercised.

To illustrate this point, Merrill Lynch recently calculated that profit at companies in the chip industry would have declined 6 percent on average in 001 if they had expensed options. Intel, for example, would have had net income of $54 million instead of $1. billion. 4

Expensing stock options would move earnings closer to a true earnings figure. Stock options are compensation for employee services, and compensation should be reported as an expense. Alan Greenspan recently commented, “I fear the failure to expense stock option grants has introduced a significant distortion in reported earning-and one that has grown with the increasing prevalence of this form of compensation.” 5

II. Informed investors

Investors have recently been burned due to financial misconduct by several companies. This makes investors leery of information provided by companies about their financial standing. It is important to boost investor confidence (for the sake of our economy) by providing a full and accurate picture of a company’s financial position. Since options do not currently show up on income statements (reported as zero then included only in the footnotes), it may appear companies are hiding pay. This is not the way to regain the average investor’s trust. By expensing, we may move reported earnings closer to true earnings and make general investors more aware of their effects on income. By excluding, investors are less informed than they should be about the true input cost of creating corporate revenues. Alan Greenspan said in his May third speech “Capital employed on the basis of misinformation is likely to be capital misused.” 5

He also made these comments to further support this point “In recent years, substantial capital arguably was wasted on a number of enterprises whose prospects appeared more promising than they turned out to be. This waste is an inevitable byproduct of the risk-taking that generates the growth in our economy. However, the amount of waste becomes unnecessarily large when the earnings reports that help investors allocate investment are inaccurate.” 5

The ‘cons’ of ‘expensing’ stock options

I. Damaging to companies

Some companies contend that if they are forced to expense stock options, (1) raising capital will become more difficult and () the use of options as employee compensation will decline sharply. The logic is this Expensing causes lower reported earnings, and the lower earnings can cause a lower stock price. Due to the lowered stock price, (1) investors will be dissuaded to pump cash into the given company, () employees will not find stock options as attractive, and companies will curb use of options for employees.

The high technology sector is the most vocal in its opposition to expensing options. Stock options make up the majority of compensation for employees because they do not have the cash needed to attract and pay quality people (they are relatively new, start-up companies). Options are used as a promise for big money in the long run. Small high-tech companies believe that they will be placed at a competitive disadvantage with larger companies that can withstand higher compensation charges in the short run. 1 The impact on profits for larger companies is equally significant. A study of Microsoft, the worlds largest corporation based on market capitalization, found that its 18 profit of $4.5 billion would actually have been a loss of $18 billion had its stock options been treated as wage expense. 6

In response to this opposition, which was based primarily on economic consequences arguments, the FASB decided to encourage, rather than require, recognition of compensation cost based on the fair value method and require expanded disclosures. 1

Not all companies agree that expensing will cause significant damage. Many are beginning to make the move towards expensing. 7 The tech community is one voice being drowned out by an entire chorus of voices supporting expensing, an economist recently said, adding that General Electric and about 10 other companies have pledged to begin reporting stock options as an expense. 4 Most of these companies, though, will see very little impact on their earnings per share because they don’t have the large amount of options outstanding that high-tech companies do.

II. Valuation of Options

Opponents of expensing complain the current methods used to determine the value of employee stock options are flawed and subjective. Opponents contend many press reports on the options controversy convey an impression that valuation is a simple matter of plugging numbers into a well-accepted model. It is not that straightforward. Option valuation models require the input of highly subjective assumptions including the expected price volatility of the stock. Because the options granted to employees are not tradable and have long contractual lives and changes in the subjective input assumptions can materially affect the fair value estimate, the models do not necessarily provide a reliable measure of fair value of the option. 8

For example, the Black-Scholes option pricing model most commonly used to value options was not intended to handle employee stock options. It was designed to value readily tradable stock options with relatively short lives and no vesting restrictions. Employee stock options cannot be traded and are lost if an employee leaves before they are exercised. Opponents argue both of these restrictions should result in a price discount which should be factored into the pricing model, but because theres no market standard, FAS 1 doesnt allow companies to estimate what the discount should be. (The Financial Accounting Standards Board does define a calculation for expected pre-vesting forfeitures.)

Alan Greenspan commented on this subject in a recent speech addressing the options controversy “Some have argued against option expensing on the grounds that the Black-Scholes formula, the prevailing means of estimating option expense, is approximate. It is. But, ..., so is a good deal of all other earnings estimation.” 5

The argument concerning the accuracy of the current pricing models is valid, but it still doesn’t prove that options shouldn’t be expensed.

III. Financially accurate without expensing

Some opponents contend that since expensing is required in the footnotes, investors can flip back and subtract the options expense from the earnings statement. The availability of this information makes it unnecessary to require expensing in the body of the statement. Opponents also believe that markets are generally efficient and that share prices reflect available information, so it really doesnt matter if a firm deducts the options expense from earnings as long as the options are disclosed-which they are.

One study that supports this belief is a study by the Federal Reserve that points out there is a self-correcting mechanism with stock options as they affect share prices. The Fed study found that the more options a company grants the less it pays out in dividends, which reduces share prices. Money that would otherwise be used for dividends is used to repurchase shares for exercised options, which prevents dilution. Other studies have found that granting options to senior executives improves their performance, thereby raising profits and shareholder value. Ultimately, in a rational market, stock prices should already reflect the impact of stock options, causing them to be priced correctly. 6

The assumptions in the previous paragraphs are (1) the market is rational and () investors are savvy enough to pick up on information contained in the footnotes. These are dangerous assumptions when you the average investor considering floating money into a stock.

Calculating the expense

To comply with the Statement of Financial Accounting Standards(SFAS) No. 1 “Accounting for Stock-Based Compensation”, companies offering stock based compensation plans must determine the fair value of the options. The Financial Accounting Standards Board (FASB) then gives companies a choice concerning reporting of options. They may use either the fair value method and recognize expenses in the income statement, or the intrinsic value method and disclose in the notes the pro forma impact on net income and earnings per share (if presented) as if the fair value method had been used. 1 Both methods are explained below.

I. Intrinsic value

Intrinsic value is the difference between the market price of the stock and the option’s exercise price (the specified price at which the employee can purchase the stock) at the grant date (the date when the employee is awarded the option). Total compensation cost is determined at the grant date and allocated to the periods benefited by the employee’s services-the service period. The service period is usually the vesting period-the time between the grant date and the vesting date (the date when the employee controls the exercise of the stock option). 1

II. Fair Value Method

Using the fair value approach, total compensation expense is computed based on the fair value of the options that are expected to vest on the grant date. A company can deduct the “fair value” of an option as an expense at the time the option is granted, allocating the cost over the vesting period of the option. (The time of recognition is the same in both methods, only the valuation is different.) Fair value at the grant date is estimated by using an acceptable pricing model. An acceptable pricing model estimates option value based on the following factors which determine its underlying value (1) Volatility of the underlying stock, () the expected life of the options, () the risk-free rate during the option life, and (4) the expected dividends during the option life. The Black-Scholes method is the most commonly used model in valuing options. 1

Black-Scholes Method

The Black-Scholes option pricing model, for which its originators won a

Nobel Prize in 17, is indeed a powerful and useful tool. It values options

according to six factors. Four are known the exercise price, the market price,

the current market rate of interest, and the term of the option. One is more-or-less known dividends. For high tech companies, dividends can be safely set at zero. The last factor is the most difficult the expected volatility of the shares.

Since FASB does not require the Black-Scholes method, just a method that meets the criteria for pricing models, that leaves the door open for companies to use different pricing models. Enter Coca-Cola. One of the first companies to announce plans to expense options, Coke plans to determine fair value by soliciting bids from at least two investment banks and averaging the result. The plan was devised by board member Warren Buffett. There are a lot of decisions that need to be made when you apply Black-Scholes, and they are subjective, explains spokesperson Kari Bjorhus. We felt it would be more fair and objective to ask third parties.

Issues related to calculating expense

The FASB strongly urges companies to use the fair value method, but almost no one does. Instead, they use intrinsic value (the difference between the grant price and the market price). This is almost always zero because options are usually priced at the market value at the time of the grant (market price=$50; option price=$50; $50-$50=$0). The fair market value is then put into a

footnote.10 The opposition comes from the push to use the fair value method because use of this method could cause earnings to be reduced drastically in some situations.

Other Issues

A related concern is the dilution of equity when employee stock options are exercised. The greater number of shares outstanding after exercise means

proportionately lower earnings available to the original shareholders. If properly accounted for, observers believe that investors will become fully aware of this dilution and many share prices will appear far overvalued, leading them to fall sharply. 6 If reported earnings fail to deduct stock options, this may mislead investors and keep them in the dark about the size of the future earnings

dilution. In sum, this argument suggests that investors need better estimates

of earnings in order to value equities properly.

The line is drawn. Investors and legislators stand on one side and

companies on the other, though a few companies, such as Coca-Cola, have now

agreed to begin expensing options.

1 Intermediate Accounting Textbook, Tenth Edition; Kieso, Weygandt, and Warfield.

“Reforming stock options in the Post-Enron, Post-WorldCom Era,” Rosen, Corey; July 00. www.nceo.org/library/reforming stock options; November 5, 00.

“Deducting the Options Expense Much Ado About Nothing,” Strategic Finance, October 00; Deshmukh, Howe, and Luft. InfoTrac Web General Business File; November 4, 00.

4 “National Business Panel Supports Expensing Stock Options,” Knight-Ridder/Tribune Business News; September 18, 00. ETSU Library Online Article Search, InfoTrac Web Info Trac OneFile; November 4, 00.

5 “Stock Options and Related Matters,” Remarks by Chairman Alan Greenspan; May , 00. www.federalreserve.gov/BoardDocs/Speeches/00; November 1, 00.

6 “How stock options affect Corporate Profits,“ Bartlett, Bruce; September 8, 1. www.ncpa.org; November 5, 00.

7 “Expensing those Expensive Options,” What you need to know about stocks. www.stocks.about.com/library/weekly; November 5, 00.

8 “Expensing Stock Options Is a Faddish Fraud,” Alan Reynolds; July 18, 00. www.creators.com; November 1, 00.

“The Value Proposition,” CFO, The Magazine for Senior Financial Executives, October 00; Tim Reason. InfoTrac Web General Business File.

10 “The Stock Options Controversy And The New Economy,” James V. DeLong; June, 00. www.cei.org; November 1, 00.

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