Should Companies Expense Stock Options? 418
A reader writes : "The New York Times is running a story about proposed accounting changes to force companies to expense stock options. Is this a necessary and proper oversight measure to enforce financial discipline on companies that might otherwise have none? Or would this measure basically stop companies from offering fiduciary responsibility incentives to their employees? What do you think about this? What should the final decision be? And what measures should be taken to influence the decision-making process?"
Fiduciary responsibility incentives? (Score:5, Interesting)
Perhaps this was a typo for "fiduciary irresponsibility incentives"?
No "duh" (Score:2, Interesting)
Taxes (Score:3, Interesting)
YES! (Score:3, Interesting)
I think it's a horribly dumb idea to pump up corporate profit on paper just so the tax man can take a bite bigger than your real profit out of your fake profit. I guess that's one of the problems with publicly traded corporations though - shareholders are often too uneducated to realize that long-term gain is more important than short-term illusion of profit.
That depends. (Score:2, Interesting)
Will my stock be worth less when those options are exercised, en masse, by employees fleeing a sinking ship? If the answer is yes, then companies should expense stock options.
In fact, it's amusing that this even requires discussion. Options are like any other debt, except that the eventual cost of paying off that debt is unknown. Companies are required to report outstanding debt. Why should options be any different?
Re:Taxes (Score:4, Interesting)
Yes , the companies would get a tax break by this ( their taxable earnings would be lower ) , but a lower earnings would also drive their stock price down.
Imagine the effect on stock price of everyone's favorite enormous software company if they were to report employee stock options as expenses. It would nearly wipe out their earnings , which would drive their stock price down precipitously. Which amusingly enough would also drive down the value of the stock options themselves ...
!options then compensation = salary (Score:3, Interesting)
If companies have to expense options, they'll drop the option programs as the expensing will kill profitability. Therefore companies will nolonger give out options (MSFT has already stopped giving out options), and thus the major $$$ form of compensation will be salary, and salary does not keep an employee at a company for a long time, as you can jump ship to another company easier to get a raise than to ask mgmt.
Plus many companies spend big $$$ repurchasing stock on the market to keep up the stock price.
Lastly, if options are expensed then only the execs will get options and not the workers in the trenches.
HockeyPuck ---> .
goodwill (Score:3, Interesting)
Goodwill, to first define, is the premium paid for another company above what they are physically worth (buildings, equipment, patents, etc.) Therefore, if Co. A buys Co. B for $20 mil, and there are only $15 mil of physicaly goods, $5 mil is goodwill.
So the question now, is why expense (impairment is the technical term) it if the value of goodwill goes down? Because it is a consistent treatment of company especially intangible goods. If a company has a 15 years of a patent left to amortize, and for whatever reason it is invalidated, or maybe a new advance comes out making that patent obsolete,the comapny should properly impair the value of the patent, just as goodwill is now treated.
Two things we accountants like are comparability and consistancy. impairment of goodwill brings both of these to the table. After all, if SCO had any goodwill in the accounting sense, they should probably write off quite a bit of it, as they have likely drastically reduced the value of said goodwill.
thng
Re:Yes (Score:4, Interesting)
Not a good question for /. (Score:1, Interesting)
Options are nothing more than a promise to offer stock to someone at a fixed price in the future. If that fixed price is less than the market price, the company misses out on possible capital. This is the amount that people want to turn into an expense. How the heck do you account for that ahead of time? If you wait to account for it when the option gets exercised, it skews your earnings reports because of it reflects prior payroll, not current payroll. You can't just go back and drop it on the books for the date the option was given, because it'd be years before you could finally close the books on a given fiscal year.
In short, there is no simple answer for this question, so quit trying to find one and let the bean counters figure this one out.
No - stop rigging the system (Score:2, Interesting)
What else do you expect from the president who appointed the head of Alcoa, the practically medieval aluminum mining and manufacturing company, his first Secretary of the Treasury? Who proved unable to do anything to assist the bubble's soft landing, even when the rest of the White House would talk with him? The only thing President Vice President Cheney likes about tech companies is that they waste a lot of expensive electricity - so he'll make their finances as complex as possible, requiring his buddies at Anderson *cough* Enron *cough* Accounting to get their piece of the action if they show any green - cash - at all.
Re:Warren Buffett's take on it (Score:4, Interesting)
Right now, companies already expense the cost of the capital appreciation of the share sold when the option is exercised. How? Stock buybacks. When a stock option is exercised, the employee is sold a share out of the option pool (which usually means there's no dilution). The company books this cash as a share sold, just as if it was sold on the open market (but at the lower option strike price instead of fair market value). Eventually, that share is bought back (most companies continuously buy back shares) and the cost of that buyback is expensed. What is up for discussion is if/how to expense the option value of the option, not the capital appreciation of the underlying share.
Also, consider that many of these options will go unused, either because the employee leaves the company before they vest or because the options are underwater when they expire. The FASB recommendation permits companies to make allowances for these situations, but those allowances will always be wrong. The FASB permits similar allowances for bad debt and other estimations on the pro formas, but those entries are made up of many transactions, and they will statistically approach a historical value. Stock options are typically granted to many employees at once with the same strike price. This will appear as a single transaction-- instead of multiple, offsetting errors, companies will have single, large errors. This will drive more volatility than the other estimations on the pro formas.
I agree with Buffet that options clearly have value-- otherwise employees would not value them as compensation. I also agree that some method should be employed to correct the pro formas for options. But, the two major mechanisms recommended were designed to estimate fair market value, not the impact of an opportunity cost to a company's financial situation. I think using them in this way is not accurate. In fact, I think it will make the pro formas less accurate.
In the interim while we wait for the accounting wizards to come up with a better solution, I think it makes sense to just continue doing what most companies do today. If you look the 10-K for most companies, you will find extremely detailed option data. Using this data, you can compute the "expense" to the company in any way you find best. If the SEC requires companies to bake this in to the pro formas, it will be much more difficult to unwind the financials to use your own technique.
Yes, it will be more effort than just looking at the Net Income line or doing a quick ratio (or a Quick Ratio). But, investing in individual securities is not for amateurs (and I include myself if this category). That's what mutual funds are for.
Re:Accuracy (Score:4, Interesting)
There is no reason that options shouldn't be expensed. Options are used as employee compensation. You expense payroll why WOULDN'T You expense options.
FYI In the foot notes you do get the number of outstanding options and their diluitive effect on the outstanding shares but nobody reads the footnotes. Hell I think most people don't even read the financial statements.
Giving real shares and not options (Score:3, Interesting)
However, I favor stock option expensing, even though it would most likely reduce the number of options that are awarded to employees (since the company would have to bear an increased accounting cost for each option that is awarded). The reason is that it is more honest. The profit from exercising stock options comes out of the pockets of the stockholders who were suckered into paying full price for the stock! As a stockholder, I am annoyed that optionholders can "stealth" themselves from company expense reports, as is currently done.
Microsoft has a truly good idea, that I read about a while ago: issuing real shares of stock, not just options. This neatly avoids the entire debate regarding the accounting of stock options. Employees would be paid in real shares of stock, in addition to cash. This has all the benefits of encouraging employees to take a stake in company performance, as options do, and motivates employees to want to make the stock price rise.
Issuing real shares of stock would easily be accountable, and would also have added the benefit of being fair to all employees, not just the few who got in early and got the coveted "below-a-dollar" options....
expensing won't fix anything (Score:2, Interesting)
Expensing stock options will not make executives more honest. You could ban options all together and the execs would find another way to line their pockets. The current problem with options and executives is that it creates a pump and dump incentive. Execs can show a good quarter or two, talk up the prospects and then dump their dump stock at a tidy profit. Fixing this really requires stronger corporate governance rather changing accounting regulations.
If the corporate boards really represented shareholder interests, there wouldn't be this problem since those boards would not allow compensation packages to execs that ran counter to the shareholder's interests. I'd start by banning board membership by anyone who works for the company in any other capacity, CEO included. Board members should only give execs options that are exercisable after several years and at a premium to the current price to account for inflation. This way the execs would have to create some lasting shareholder value to reap a windfall.
The expensing formulas can't capture the real value of the option. The only real way to figure out the value of the option would be to make them tradable and not expire on termination of employment. The proposed formula's are just a bean counters guess and will underestimate the value for companies that do well in the future and will grossly overestimate the value for companies that do poorly.
Furthermore, putting non-cash charges into earnings reports makes it really hard to understand the reports for those of us who didn't go to business school. It's already almost impossible to figure out what a companies cash flow from operations was from an earnings report because of all the stupid non-cash charges like goodwill amortization. Goodwill amortization is much like stock option expensing in that it makes the bean counters feel better but confuses everyone else. It's a lot easier for the dishonest to cheat when no one can under earnings reports and balance sheets due to the cluttering off them by make believe (non-cash) charges
Re:Fiduciary responsibility incentives? (Score:3, Interesting)
In privately held companies, stock is issued depending on the perceived value of the company and what monies investors have put up. While there is no true value, this stock is an indication of what percentage an investor 'owns' in a company. If the company is sold, the proceeds are split up depending on the stock ownership. It is not uncommon in those instances too for all options to become immediatly vested, the same is true of an IPO event.
As part of the intial funding, it is not uncommon for companies to set a specific amount of stock to be issued for internal use, often with very specific vesting periods to entice employees to stay. When employees leave, they are often required to excercise those options within a specific period or they are lost. When excercised, those funds are then made available back to the company. Of course, an employee can buy options at any time once they are vested, but I don't know if any reason to do so in a private company since there is no one to sell them to. I can see a reason for 'expensing' these options so that the later funds received offset them.
Now, here is where it gets fun. After an initial investing round, companies are often enticed by other investers or pursue new ones, and the games begin. The new investors try to convice the company that the company is not worth that much so they can get a bigger percentage of the company. The current investors don't want that to happen because whenever someone buys in after they have, their shares get 'diluted' because new shares have to be issued. Someone who owned 10% of all shares now only own 9.1% because 10% more shares were issued to the new investor to get their $50M.
The current investors want the money from the new ones, but they don't want it at the risk of losing a significant percentage of ownership. Of course, this can all be easily dealt with if everyone who invested before chips in, but even that is fraught with one-upmanship games.
In a roundabout way, this game the companies cash position. The number of stock issued (including options), their perceived value, and the future perceived worth of a company all impact the ability for companies to entice new investors. While this cash position is not tangible, it is very real and can make or break a company. If the company needs cash but has over extended its stock, it makes it very easy for a new investor to come in and set their own terms, sometimes diluting current shares to the point they are not worth anything.
Re:Fiduciary responsibility incentives? (Score:2, Interesting)
It's getting a ton of political pressure because current option plans really do not do a good job of aligning shareholder and management issues. The goal of these plans is to make a considerable amount of management's pay to be based on the same (or similar incentives) as shareholders have (increasing stock prices, preferably faster than competitors). The political issue is that management only has to increase the stock price long enough to cash out their options, and may engage in risky behavior in the hope of a one time payoff. A better plan to do this would be to lengthen the period when an owner cannot exercise their options and index the strike price to either an index (like the S&P 500) or a group of competitors. ie if you issue options at $100, and after the first year the average return of your competotors was 10% at the end of the first year the new strike price is $110. If you couldn't exercise for 10 years, this would be much closer to what shareholders want.
The black magic comes from the Black-Scholes model, which uses an estimate of volitility to estimate value based on the chances that an option will finish in the money.
Companies already do have to report numbers, and estimated value, of options issued, the ranges of strike prices of options outstanding, but this information is not used on the income statement, which is all most investors look at.
Personally, I'd like to see operating cash flow reduced by the amount of cash required to not dilute current option related stock issuances, and see option plans that were longer and indexed (all but the crappiest company didn't go up over a 10 year period, which is all current options require to start transfering management value).
Re:The Financial Account Standards Board disagrees (Score:3, Interesting)
Stocks are "worth" what anybody is willing to pay for them -- a stock quote is just the going market rate at that point in time. Companies that give shares of stock as options are simply agreeing to sell the shares at a pre-determined price, either absolute or as a percentage of the market rate (depending on how it works at the company in question or in the contract).
Imagine I have 3 million widgets which other people are willing to pay me $50. But I like you, so I say, "benzapp, you're doing a good job. I'll give you a widget for just $2 instead of the $50 that other people would pay for it." Now you can buy it from me and turn around and sell it to some sucker for $50. That's where the $48 magically appears -- it's not "gone" anywhere, it came out of someone else's pocket.
The question is... (Score:4, Interesting)
So the question is, what's the most disadvantageous for Microsoft?
60% drop in earnings (Score:5, Interesting)
According to Bear Stearns, there would be a 60% drop [sfgate.com] in profits if the new rule were imposed. Think about it. Earnings in high tech companies are so dependent on stock options that these companies will "experience" a huge drop in profitability. Conversely, how can you support an accounting trick that buffs the profit of the industry by 150% (the reciprocal of a 60% drop)?
Bottom line. Profits are grossly overstated industry-wide. Why shouldn't we have accounting that reflects that reality? Why should we let this fiction continue? Are we going to forget the lessons of the dotcom bubble? Accounting tricks do work. And investors and employees can and are scammed by them. Finally, why do we need to fight so hard to get valid information about a company? It's just wasting our time which collectively is more valuable than that of a few company accountants.
See here [slashdot.org] for more discussion of this particular story. That's where I got the link BTW.
Re:Well duh. (Score:5, Interesting)
What it DOES do is validly reflect that it *does* cost the company value to have granted those options. Had the company not issued those options they could have sold those shares at full market value and had that much more cash. Effectively that *is* what the company is doing, and handing that cash to the optioned employee.
The difference between giving the emplyee that option and him selling the stock, and the company selling the stock and giving the employee the option value in cash, it is pure bookeeping games. The final result is the same therefore the final accounting totals should be the same.
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How does crap like the above get modded up to +5? (Score:2, Interesting)
Re:Well duh. (Score:3, Interesting)
No, you're guessing wrong. Like the parent post said, his options aren't worth anything, and chances are he is not going to be offered any options any time soon.
The people that should be worried are the *executives* of the company. Nowadays, the only people benefiting from options are top executives. When their options aren't worth anything, they simply reissue themselves a new batch of options at a more attainable strike price.
Accountants, please answer this (Score:3, Interesting)
Re:careful with options, please! (Score:2, Interesting)
one of the key issues, tough, is:
at what strike price options should be granted?
the strike price of an option is the price at which i have the possibility, but not the obligation, to receive the underlying stock. if the stock price is already ahead, the option is "in the money", meaning that if I could exercise it now, i'd make a gain.
since options can be exercised only in future dates, intereest rates come into the picture, but broadly speaking, we can say:
options granted at prices below or close to the going price of the shares = cokmpensation;
options granted at prices higher than the going price of the shares + interest at going rates = incentive.
there was a going joke in the good ol' days: the whole of Enron management goes to a strip joint to celebrate another good year of hard work. one of the ladies, after a bout of pole-vaultin', goes on all fours to one of the guys, looks him in the eye and says " I'll do anything for you. absolutely anything." and quickly, he answers:
"reprice my options"
( repricing is a practice by which companies lower the strike price of the options granted, whereby making them much more valuable)