BUSINESS & SECURITIES

Accounting for Stock Options:
Change at Whose Expense?

May 2002

By Denis J. Maloney*
for New Hampshire Business Review

Are you ready to add another item to your list of worries affecting your company's financial performance and stock price? Alan Greenspan keeps mentioning the issue; Warren Buffett has talked about it for years. Now, in the aftermath of ENRON — which has caused investors to question the legitimacy of financing transactions reflected in financial statements, ongoing issues of auditor independence and the reliability of advice and predictions from the Wall Street analyst community — let's add one more item that could negatively impact reported earnings at almost all companies. We are talking about accounting for stock options — whether the economy, the investment community, stockholders and companies themselves would be better served by requiring the "value" of stock options to be expensed on financial statements.

An option gives an employee the right, but not the obligation, to buy a share of stock in the future at a predetermined price — the more the price of the stock goes up the more valuable the right becomes. Options give employees a stake in their company's future. Options give a young (or 'old') company the chance and ability to grow: it can use its scarce capital funds for growth, not compensation expense.

Current accounting rules provide that the value of an option is not required to be expensed on a company's income statement. A company is, however, required to report its earnings per share on the income statement on a basic and on a 'diluted basis,' the latter taking into account the potential reduction in the ownership of existing shareholders due to the grant and exercise of options. Accounting rules also require the disclosure of additional information with respect to the potential impact of options on earnings in the notes to a company's financial statements. On the tax side, when an employee exercises an option, generally speaking the company can take a deduction from its gross income for the gain realized from the option (thereby reducing its corporate income taxes) when the employee recognizes the gain and is taxable thereon.

In recent articles on the subject, The New York Times has reported that options were "the source of more than half of most top executives' compensation last year." The Wall Street Journal similarly writes of support for existing option accounting treatment at not just "new" tech firms but at old-line companies as well as "what they have at stake is very dear to them — the compensation of their chief executives. The average CEO at one of the nation's largest companies has been earning about $2 million a year in cash compensation, but an additional $10 to $15 million in options."

If options are such a valued form of compensation, why aren't their costs reflected on the income statement like all other forms of compensation? Options do have a value when issued that can be reasonably approximated by commercially accepted methodologies developed for options trading (i.e., a mathematical formula called the Black-Scholes model). For example, an investor may, for a price, purchase an 'option' in the marketplace to acquire a share of stock at a set price in the future. Alan Greenspan feels that the failure to expense stock options has introduced a significant distortion in reported earnings that has grown with the increasing prevalence of this form of compensation. In recent speeches to business leaders, he has repeated his belief that the present accounting treatment for options has had real negative effects — fooling investors into paying unjustified prices for certain stocks and thus contributing to the boom and the bust in share prices. Taking a cue from the recent ENRON fallout and the renewed emphasis on corporate earnings, he has argued that the issue is not just one of accounting but of financial stability. Mr. Greenspan also points to the earlier debate on accounting for changes in retirees' health-care liabilities; a change to reflect such costs on the income statement itself (and not just elsewhere in the financial statements) has in his opinion caused companies to finally get serious about holding down health-care costs.

While agreeing that there is nothing wrong with the aim of encouraging stock ownership in employees, proponents of change also argue that our reliance on stock option compensation has inordinately caused company management to focus on actions to drive up the price of their stock in the short term in order to provide continuing value for their option programs — actions not focused on growth in long term shareholder wealth. For example, in recent years companies have engaged in extensive repurchases of their own company's stock in order to keep the price up and to absorb newly issued option shares without a significant dilutive effect to existing shareholders (and, the cost of repurchases, like the grant of options, is not an expense reflected on the income statement). Further, recent actions by large option issuers have given pause to the rhetoric concerning the incentive nature of options. With the drastic decline in share prices, particularly at tech-oriented ventures, large option issuers have taken two approaches to retain the incentive nature of their option programs: one, issuing new options at a lower price (so much for incentives); and two, canceling old options and waiting six months and one day to issue new options (makes one wonder what incentives management has to cause the share price to rise during such period).

Proponents of change argue that companies should replace option programs with plans that in their view actually encourage and reward stock ownership. Warren Buffett's Berkshire Hathaway rewards employees with cash bonuses, not options; he believes option incentives are too remote to influence employees — with an average five-year vesting period, an individual employee's efforts are buried in the group and the entire value of such compensation depends on a large number of factors, including the health of the overall economy. If our post-ENRON concern is that a company's income statement bear a reasonable resemblance to the shareholders' actual share of corporate earnings, then companies with large option programs have indeed shifted employee compensation "off" the books — creating artificially high earnings that have the potential to mislead.

Management looking at a mix of forms of executive/employee compensation can count at least for the short term on the status quo remaining constant for the treatment of stock options — positive accounting benefits (not reflected as compensation) and positive tax benefits (gain from exercise of option reflected as compensation deduction) — and no one argues that more employee stock ownership is a bad thing (except perhaps for employees whose shares are 'trapped' in their company's 401-K plan — but that's a story for another day). Change may be on the way, however, and we may never again see a better mix of incentives to adopt and encourage option programs. Management should review their company's stock ownership plans with an eye towards increasing equity incentive plans available to their employees, whether options, restricted stock grants or employee stock purchase plans — in order to develop a mix of incentives that will likely result in improved productivity and profitability for the company, its executives, employees and shareholders in the short and the long term.

*Denis J. Maloney is admitted in New Hampshire.

Return to top of page

Return to Business & Securities Articles
Return to Firm Publications