Stock Options

[ciba]

Until the recent FASB changes, stock options were not dealt with as an expense on the income statement. They were reflected in dilited EPS and other measures.

I don't see how expensing stock options accurately reflects their impact on a company.
Assuming:
First, no company assets are depleted by stock option grants.

Second, the company incurs no additional liability in a rational marketplace, considering the issuing of stock will simply dilute shareholder's equity, but not the value of the shareholders equity (as an item on the balance sheet).

So, are stock options expensed to compensate for an irrational marketplace, or are they expensed simply because we have swung the pendulum back to far in terms of accounting standards (moving to become more conservative)?

 

[Orsorum]

Link to the SEC's rationale, or at least one mention of it that I readily have on hand. It is my opinion that it's largely blowback from Enron, MCI, etc., and the recent push for it is the FASB's revenge for political wrangling in the early 90s (including threats of removing the FASB's status as a standard setter).

There are a whole host of considerations that come into play in a decision like this; if this thread hasn't died by Friday I'll give my thoughts on some of them (audit final tomorrow and a business policy final on Thursday).

 

[Michael]

ciba,

If I paid out stock instead of salary, would you expense that?

If you had two offers from otherwise identical companies, both at the same base salary but one offered options and the other didn't, which one would you choose?

The problem with your line of thought is that your theory on the valuation of the stock is wrong in all but a narrow set of cases. Paying options for service is not in the set of cases where your theory would be true.

If you read the FASB link I gave you in the other thread and just read the section where they discuss why they want to expense options, then you'll see why that is the correct accounting.

Michael

 

[ciba]

Originally posted by: Michael
If I paid out stock instead of salary, would you expense that?

If you had two offers from otherwise identical companies, both at the same base salary but one offered options and the other didn't, which one would you choose?

I'm confused. How does the benefit to the employee impact what the company should recognize on its financial statements? If you look at it from an employee perspective, it certainly seems like it shoudl be a company expense.

The problem with your line of thought is that your theory on the valuation of the stock is wrong in all but a narrow set of cases. Paying options for service is not in the set of cases where your theory would be true.

If you read the FASB link I gave you in the other thread and just read the section where they discuss why they want to expense options, then you'll see why that is the correct accounting.

I guess the ultimate question I'm getting at is: What asset is used up or additional liability incurred when you issue stock to an employee?

Note that I'm not saying the cost to shareholders of corporate stock options shouldn't be publish. I'm just failing to understand how options really are an expense.

 

[Michael]

ciba,

If I could take the options granted and sell them in the open market, I would get cash for them right? So what is the difference between giving this "asset" to an employee for services and retention? I'm consuming an asset in return for services, right?

What makes paying someone options in return for service any different than the other ways of paying people for services?

The question around expense vs. not expense has not really been on the level of is it an expense. The argument has been that the valuation methods currently being used are too inaccurate and cause distortion in the valuing of the options.

Michael

 

[Fern]

Originally posted by: Michael
ciba,

If I could take the options granted and sell them in the open market, I would get cash for them right? That's debatable. Most options granted to exec's are at current FMV. While you get cash for actual stock, you would get little for the sale of such options So what is the difference between giving this "asset" to an employee for services and retention? I'm consuming an asset in return for services, right? As you prolly acknowlege, options are not an asset from the companies perspective. Stock etc is reported on the Equity section of the Balance Sheet, not the Asset section

What makes paying someone options in return for service any different than the other ways of paying people for services? Most importantly, one doesn't know at the time the option is granted if it will ever be excersized. Stock prices have been known to go down, no?. Paying someone in cash is easily quantifiable. Options are not, nor do they deplete companies' assets. It's merely a dilution (if even excersized) of shareholder % ownership. Therefor it belongs on the balance sheet, not a Profit & Loss Statement.

The question around expense vs. not expense has not really been on the level of is it an expense. The argument has been that the valuation methods currently being used are too inaccurate and cause distortion in the valuing of the options. Yes they are inaccurate, given that you may well end up taking an expense for a transaction which never happens (i.e., options not excersized). Further, if options are expensed for GAAP purposes will they do away with dilution information? If not, are "accounting" for the same transaction twice? (once as an expense, second as a dilution). If so, this could penalize companies which offer options.

Michael

This question is far too complicated to be dealt here. Anyway, I'm posting a response mostly cuz I wanna know how in the h3ll you have 3,000+ posts and are still a "Senior Member"?

Fern

 

[Orsorum]

Originally posted by: Fern

Originally posted by: Michael
ciba,

If I could take the options granted and sell them in the open market, I would get cash for them right? That's debatable. Most options granted to exec's are at current FMV. While you get cash for actual stock, you would get little for the sale of such options So what is the difference between giving this "asset" to an employee for services and retention? I'm consuming an asset in return for services, right? As you prolly acknowlege, options are not an asset from the companies perspective. Stock etc is reported on the Equity section of the Balance Sheet, not the Asset section

What makes paying someone options in return for service any different than the other ways of paying people for services? Most importantly, one doesn't know at the time the option is granted if it will ever be excersized. Stock prices have been known to go down, no?. Paying someone in cash is easily quantifiable. Options are not, nor do they deplete companies' assets. It's merely a dilution (if even excersized) of shareholder % ownership. Therefor it belongs on the balance sheet, not a Profit & Loss Statement.

The question around expense vs. not expense has not really been on the level of is it an expense. The argument has been that the valuation methods currently being used are too inaccurate and cause distortion in the valuing of the options. Yes they are inaccurate, given that you may well end up taking an expense for a transaction which never happens (i.e., options not excersized). Further, if options are expensed for GAAP purposes will they do away with dilution information? If not, are "accounting" for the same transaction twice? (once as an expense, second as a dilution). If so, this could penalize companies which offer options.

Michael

This question is far too complicated to be dealt here. Anyway, I'm posting a response mostly cuz I wanna know how in the h3ll you have 3,000+ posts and are still a "Senior Member"?

Fern

I don't think it's too complex to be discussed, but I don't really have a response beyond what you've already posted. In my opinion expensing stock options would be inaccurate and inconsistent with GAAP; diluted EPS calculations more accurately reflect the eventual effect on shareholders.

The BSM model was not designed for ESOs, it was designed for short-term options available on the open market. I've tried to do some research on the binomial lattice method (as it brings many more variables into account such as suboptimal decision making, probability of stock price declines, etc), but I haven't had the time. Ah, ATPN, my catalyst for learning.

 

[Michael]

Fern,

Out of curiousity, what is your background? I'm a Chartered Accountant (Canada) who lived in the USA for years and now am in Asia as the CFO of a large public company.

"That's debatable. Most options granted to exec's are at current FMV. While you get cash for actual stock, you would get little for the sale of such options"

The option of purchasing a stock at a set price (usually at the price at the time the stock was issued) for the next 10 years certainly has a value. With the number of underlying shares usually being pretty large, it actually can be a pretty high value. If you look at the huge profits some people have been able to make, you can see that the value can be very large.

If you accept a simple 8% average rise in the value of stocks over a 10 year period, it is easy to show the value. If the stock was at $10 when the option was issued, each option is worth between $10 and $11.5 (this is a very rough calculation without using NPV to bring the value 10 years into the future to present day).

You actually get pretty good value selling call options that are at strike price and are good for 1 more year. Make these 10 years and it would be much higher.

It is not correct to say that the options when granted have little value. They certainly have value. You can argue that we don't have the greatest models to predict this value, but accounting uses estimates all the time.

"As you prolly acknowlege, options are not an asset from the companies perspective. Stock etc is reported on the Equity section of the Balance Sheet, not the Asset section"

Options represent retention, increased performance by employees to cause the stock to perform plus future cash in the door when they're excercised (cash is the asset debit that goes with the equity credit for the stock). They're certainly not just Equity and they're certainly part of paying for perfromance (or avoiding expense if employees are retained).

"Most importantly, one doesn't know at the time the option is granted if it will ever be excersized. Stock prices have been known to go down, no?. Paying someone in cash is easily quantifiable. Options are not, nor do they deplete companies' assets. It's merely a dilution (if even excersized) of shareholder % ownership. Therefor it belongs on the balance sheet, not a Profit & Loss Statement. "

You don't know if it is going to be exercised, but you can estimate it. You can usually assume that the option will be exercised in the future. Unless there is a serious going concern problem, most companies are run with the expectation on increasing value and profit in the future.

There is an issue with current expensing procedures in that unexercised options that expire worthless that were previously expensed do not have the expense reversed. You can't easily value options, but you certainly can estimate their value and there is broad acceptance of this. So you can convert them into their cash value and expense them.

"Yes they are inaccurate, given that you may well end up taking an expense for a transaction which never happens (i.e., options not excersized). Further, if options are expensed for GAAP purposes will they do away with dilution information? If not, are "accounting" for the same transaction twice? (once as an expense, second as a dilution). If so, this could penalize companies which offer options."

I already mentioned the costing issue just above. You're looking at the dilution part incorrectly. The dilution is a by product of the financing of the expense. You have the expense which also results in dilution. Just picture selling the options (or some other form of equity) and then using the cash to pay the expense. Same thing.

Orsorum,

Be careful about saying expensing options is not consistent with GAAP. Actually, it has been GAAP for years. US GAAP used to have an escape clause that let you chose not to (but disclose how much it would have been), but expensing was part of GAAP.

The USA is a holdout in terms of not expensing them. Just about every other accounting regime in the world requires it.

Michael

ps - If you ever threaten mods that you have revealing pictures, you had better not be bluffing or you'll stay a "senior member" forever.

 

[Orsorum]

Originally posted by: Michael
Orsorum,

Be careful about saying expensing options is not consistent with GAAP. Actually, it has been GAAP for years. US GAAP used to have an escape clause that let you chose not to (but disclose how much it would have been), but expensing was part of GAAP.

The USA is a holdout in terms of not expensing them. Just about every other accounting regime in the world requires it.

Michael

ps - If you ever threaten mods that you have revealing pictures, you had better not be bluffing or you'll stay a "senior member" forever.

I mis-typed what I meant. IMO treating options as an expense is inconsistent with GAAP core principles. I realize that it is part of GAAP and up until this year were allowed to be solely disclosed in footnotes. Thanks for pointing that out.

 

[Michael]

Orsorum,

What GAAP core principles is it inconsistent with? I think that not expensing stock options is inconsistent with GAAP core principles and I'm curious as to what ones say it should not be expensed?

Michael

 

[Orsorum]

Originally posted by: Michael
Orsorum,

What GAAP core principles is it inconsistent with? I think that not expensing stock options is inconsistent with GAAP core principles and I'm curious as to what ones say it should not be expensed?

Michael

CON 6, Par. 80:
"Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, 42 rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations."

To be recognized as an expense, then, stock options must either be an outflow of an asset or involve the incurrence of a liability.

Also CON 6, Par. 35
"Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events."

Given that stock options are reflected in the equity portion of the B/S, I cannot see (just from glancing at this) any way that they can be expensed while remaining true to these statements.

I agree that ESOs are not simply equity: they represent a number of considerations (future performance, employee retention, etc), and that some sort of recognition should be considered so as to more accurately reflect the economic well-being of an organization. However, I don't think that expensing is warranted, nor the value of ESOs estimable.

The BSM model is not designed for valuing ESOs and misestimates their true value. Do you know anything about the status of the binomial lattice model as a method for option valuation?

 

[alent1234]

Originally posted by: ciba
Until the recent FASB changes, stock options were not dealt with as an expense on the income statement. They were reflected in dilited EPS and other measures.

I don't see how expensing stock options accurately reflects their impact on a company.
Assuming:
First, no company assets are depleted by stock option grants.

Second, the company incurs no additional liability in a rational marketplace, considering the issuing of stock will simply dilute shareholder's equity, but not the value of the shareholders equity (as an item on the balance sheet).

So, are stock options expensed to compensate for an irrational marketplace, or are they expensed simply because we have swung the pendulum back to far in terms of accounting standards (moving to become more conservative)?

giving out stock options dilutes the current shareholders while forcing the company to grow earnings at the rate that they want. this is the cost of capital in giving out stock options.

Say a company has 1 million shares outstanding and earnings of $1 per share in the latest FY. Investors also demand 10% annual growth in EPS. If the company were to issue 100,000 more shares it would still need to meet $1.10 EPS for the next FY.

Current FY is $1,000,000 million in earnings. WIth the dilution the earnings for the next FY will need to be $1210000 or 21% higher than the current earnings. That is the cost associated with giving out stock options even though no cash leaves the company.

Personally I don't think they should be expensed and that it was a ploy by the democrats to stop people from making a lot of money. The average salary at Microsoft was $400,000 per year in the late 1990's because of stock options.

 

[ciba]

Orsorum explained what I'm trying to get at much better than I could.

Alent1234, I agree that there is a cost to the shareholders when employees are compensated with stock options. Diluted EPS gives shareholders a "worst-case" scenario with regards to exercising options. I certainly think options should be disclosed, but expensing them seems inconsistent.

 

[Fern]

The option of purchasing a stock at a set price (usually at the price at the time the stock was issued) for the next 10 years certainly has a value. With the number of underlying shares usually being pretty large, it actually can be a pretty high value. If you look at the huge profits some people have been able to make, you can see that the value can be very large.

Last time I checked (and it has been a long time) there were no options on are market with such a lenghthy time period for excersize. Not close. Accordingly there is no "market" where one can find the FMV. Again, one would be left with estimating. However, I do agree the value is greater than "zero". But how much greater (and no, I don't care to accept estimates of 8% per annum etc)

Yes, some have earned large profits from their options. However, this is due to increasd value in the stock which has occurred in a time period after grant I don't see where such "post-transaction" accretion relates to expensing of options

Unless there is a serious going concern problem, most companies are run with the expectation on increasing value and profit in the future

AFAIK, IBM has never had a "going concern" paragraph in its financials etc. Yet in the late 80's to early 90's all the execs options were "under water".

Also, at that time Lou Gerstner was brought in. He fired his brother (a senior-level exec VP with loads of options), who thus lost all his options. Would the expense for those grants have been reversed?

I'm sure other companies have had similar experiences to IBM. Take Quanta for example. IIRC their price was about $70 in 1999-2000 approx. I hear it's now a fraction of that ($20 ?). I do not believe they have a going concern issue, but there are surely plenty of exec's holding completley worthless options.

"Yes they are inaccurate, given that you may well end up taking an expense for a transaction which never happens (i.e., options not excersized). Further, if options are expensed for GAAP purposes will they do away with dilution information? If not, are "accounting" for the same transaction twice? (once as an expense, second as a dilution). If so, this could penalize companies which offer options."

I already mentioned the costing issue just above. You're looking at the dilution part incorrectly. The dilution is a by product of the financing of the expense. You have the expense which also results in dilution. Just picture selling the options (or some other form of equity) and then using the cash to pay the expense. Same thing.

When one expenses options, Net Earnings will be reduced. One would then take the reduced earnings and further dilute them for such options. This seems to me a "double-whammy" for a single transaction.

Just picture selling the options (or some other form of equity) and then using the cash to pay the expense. Same thing.

While I agree that one can find or structure a transaction that will correspond to this expensing of options, I do not feel that alone is compelling enough to warrant this change.

The only companies which sell stock to pay exec compensation are start-ups. I am working on such a company now. Oddly enough, this just serves to dilute the loss per share.

Lets take the example of two companies, identical in every way except one offers options and one does not:

Before any rule change on expensing of options, the company w/o an option program would have a lower Net Earnings (all exec comp is expensed), but likely a higher EPS (less dilution). The company offering options would have a higher Net Earnings (due to a portion of comp being "paid" in options, not all exec comp is expensed), but likely a lower EPS (more dilution).

I see some parity here. The company which chose not to do options will have better EPS (via less dilution), the company offering options will have better Earnings. "Six of one, half dozen the other"

Now, if companies are required to expense options, both will have the same Earnings, but the company offering options will suffer dilution. Thus the company offering options will always look worse (but for the amount of cash retained via use of options for compensation). I find this to be an artificially created disincentive for companies to offer stock option programs.

On a side note (and I could be wrong as I haven't checked the tax code for changes), the companies with option programs will also suffer a tax disadvantage as the "option expense" would not be deductible. Their higher taxes would reduce cash and drive down Earnings & EPS again.

(Last time I checked, only disqualifying ISO's resulted in a tax deduction for the company)

Although I understand some of the rational for expensing options, when considering all things I still feel the old way results in the more accurate/ fairer presentaion of the two.

BTW: I'm a US CPA, most of my career in taxation with the big 8, 6 or 4 (Price Waterhouse & Peat Marwick)

 

[Orsorum]

Originally posted by: Fern
On a side note (and I could be wrong as I haven't checked the tax code for changes), the companies with option programs will also suffer a tax disadvantage as the "option expense" would not be deductible. Their higher taxes would reduce cash and drive down Earnings & EPS again.

(Last time I checked, only disqualifying ISO's resulted in a tax deduction for the company)

Barring any court rulings or Treasury regs to the contrary, I would imagine you could deduct option expenses as well, just going by §162(a). Don't know how the IRS would treat it for the individual, though, as once you treat it as income in the current year you lose much of the incentive for granting ISOs (actually, I'm not sure what the difference would be at that point...).

<-- graduating with BA Acctg in two weeks, will have a masters in tax next June. Not a CPA yet!

 

[alent1234]

20 years ago when reagan was president there was a big deal about how CEO's were paid too much and didn't have any interest in the company. Then companies started to pay less cash and give stock options to CEO's and employees. Now that GWB is president the same people don't like it either and passed legislation that almost does away with stock options.

 

[glenn1]

I don't see how expensing stock options accurately reflects their impact on a company.

It doesn't in any real sense other than to change the artificial number that is "earnings" into a slightly different artificial number. It's the accounting equivalent of a ricer; like putting an "S-type" sticker on a Honda Civic it claiming it makes the car run faster when in reality it does nothing at all. Whether you expense them, use Black-Scholes, or any other method you can come up with, doesn't alter the basic fact that "earnings are an opinion, cash is a fact." The only reason why it's even a question now is the fetish equities investors have to earnings, which has turned otherwise intelligent people into Pavlovian-response idiots. Those in the accounting field think that if the options are expensed it would somehow bring enlightenment to the crowd who will buy or sell 1MM shares a pop the instant after hearing a bulletin board rumor that XYZ Corp. will miss/beat earnings by a penny.

 

[Michael]

fern,

I glad that I'm discussing this with another accounting professional - it allows me to craft my response in a way that makes more sense. I'm at our plant in Korea right now and have limited time, so here is my quick response.

I agree that there is no ready made market for options with the same time value as employee stock options. However, it isn't like a market could not be created. For example, Microsoft brought in a bank to buy options off of employees. There is a value and it can be calculated fine enough that a bank was willing to buy the options.

Once you agree that the options have value and are being paid for services rendered, the question of it being an expense is settled and it then becomes a question of how much is the expense. As glenn1 points out later in this thread, earning per share is already full of other estimates and valuations (pesion accounting is a good example). I see nothing in expensing stock options that is any different.

The only counter to the story of options expiring worthless and yet having been expensed is that the expectation of value (should be an estimate of what they could have been sold on the open market when they were issued). Actual results may differ, but the value at the time the expense was recorded was correct. I'm not 100% satisfied with the current rules on valuing options and how they deal with cases like these, but I'm willing to live with it.

Michael