Will Expensing Stock Options Create New Problems?Published: July 31, 2002 in Knowledge@Wharton
In the wake of a series of high-profile alleged accounting abuses, stock options have gained a bad name. Top executives are under fire for mismanaging earnings – pumping up profits so they can cash in stock options that enrich them personally at the expense of their company’s health. But even as politicians and the media vilify stock options, experts from Wharton and elsewhere are asking if the blame is being misdirected, and if the solutions being adopted might bring about new problems.
President Bush, whose reputation has skidded lately over his handling of the economy, got a mild round of applause on July 30, when he signed the Accounting Industry Reform Act into law. Designed to address alleged accounting abuses and corporate fraud in the wake of Enron, WorldCom, etc., the bill creates a new oversight board for the accounting industry, quadruples maximum jail time to 20 years for executives who commit mail or wire fraud, and pours more money into the Securities and Exchange Commission.
But while the bill promises to have far-reaching effects on the accounting and business professions, the most immediate impact may be on an area that it did not even address — the way that companies account for stock options issued as a form of compensation.
Driven by investor anger and concern over possible Congressional action, companies such as Amazon.com, Coca-Cola, Bank One, Wachovia, and the Washington Post Co. have announced they will record the value of compensation-based stock options on their income statements (Warren Buffett, a strong supporter of the measure, sits on the boards of both Coke and the Washington Post). Previously, many companies limited their reporting in this area to footnote disclosure, which critics charge was often ignored by investors and analysts.
In theory, greater disclosure promotes comparability between companies. So if Company A issues a significant amount of stock options to its executives as part of a compensation plan, income statement disclosure of the fair market value of those options should make it easier to compare the results with Company B, which does not utilize stock option-based compensation; as well as with Company C, which also issues stock as a form of compensation.
The fact that companies are reporting the value of their option compensation doesn’t necessarily mean that the values are directly comparable. For example, although FASB 123 (Accounting for Stock-Based Compensation) notes that “...fair value is determined using an option-pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock and the expected dividends on it, and the risk-free interest rate over the expected life of the option...” it does not specify the exact model to be used. Although the Black-Scholes Formula is generally acknowledged to be the most widely used valuation method, the fact that other methods are available could lead companies to report different valuations for the similar option-based compensation plans.
A recent issue of the Financial Times took note of this, reporting that, “Opponents of compulsory charging of options against profits warn of confusion as companies adopt different methods of valuing the incentives...”
But adjunct finance professor John Percival disagrees. He notes that although some academics believe that reporting or not reporting is irrelevant (because there is already enough information for enlightened investors to gauge the effect of options), he believes that, “If we continue to have an income statement, then in the name of consistency we should report all expenses incurred. Options are compensation that has a cost to shareholders and should be expensed. The fact that there is more than one way to do it is not critical. That is true of many other expenses that go on accrual income statements.”
Percival adds that volatility in earnings can actually be good, because it signals that “continuing to do things like marketing, R&D and compensation, in temporarily bad times, will provide benefits in the future. More volatility now can produce higher levels later.”
For Wharton accounting professor John Core, however, it is important that the information about options was already available in footnoted format. “It might be fair to say that earnings are a little more transparent if the fair value of stock options is expensed through the P&L, instead of simply being disclosed in the footnotes,” says Core. “But in an efficient market, like the one in place in this country, analysts and investors should know about them, and the options are probably already factored into the stock price.”
He says this is because good investors do not focus exclusively on the earnings number. Instead, according to Core, “They read the entire financial statements, which include not only the balance sheet, but the cash flow statements and the notes to the financial statements as well.” In fact, he argues that additional disclosure may reduce the ability of high-tech and other firms to compete effectively.
“Politicians and regulators tend to focus on the benefits of disclosure without considering the costs,” he says. “The possible costs of additional disclosure include the potential of exposing proprietary information to competitors, and the costs of preparing additional documents.”
Compensation arrangements are already detailed in financial statements and regulatory filings, Core explains. If firms have to disclose more information about these arrangements, they may incur even more legal and consulting costs, even though investors may already be aware of the information being presented. The added costs may not be material to large firms, notes Core, but they “could be a significant burden for startups.”
Costs may also be why media reports indicate that venture capital firms are lobbying hard against disclosing stock options on the income statement. On the surface, it may seem odd that these sophisticated individuals would be concerned about a P&L effect that would appear to have no effect on cash flow. Core maintains that VCs may not be concerned with the accounting treatment per se, since it’s a non-cash item. He speculates, however, that if the change in the accounting treatment brings about an unfavorable change in the tax treatment of the options (currently, there is generally no tax liability for stock options distributed to a pre-IPO start-up’s employees), “it could raise the real economic costs VCs incur to finance their deals.”
Richard P. Shanley, a partner in the New York City office of Deloitte & Touche LLP, points out that assigning a cost to stock options and recognizing it on the income statement may make it more difficult for high-tech and other companies to attract talent, because the share prices may be negatively impacted by the more open disclosure of this non-cash cost. Other factors, however, might play a larger role. “Companies may claim that this disclosure will crimp their ability to get talent, but I think the bear market will have more of an effect,” he observes. “In fact in some ways, the P&L treatment way be a wakeup call to investors, who have recently tended to ignore items like footnotes and balance sheets.”
Shanley says he agrees with P&L disclosure of the cost of stock options. “Charges attributed to stock options should be expensed,” he says. “These charges may not be a cash item, but they do represent a dilution in the value [of the company] for future owners.” And as such, he acknowledges, they may penalize current shareholders, who bought in at a time when charges associated with options were generally not run through the P&L.
Additionally, while a degree of market turmoil may result if some companies value the options’ cost using the Black-Scholes model while others use another model, Shanley discounts the disturbance. “Most companies use Black-Scholes,” he notes. “I do not think you will see much of a distortion caused by companies using other valuation methods.”
Shanley cautions, however, that any bull-to-bear swing may be magnified when option costs are run through the P&L. “If a company recognizes the cost of options in one period, and a bear market sends the options under water in a future period, the firm may recognize income to the extent that the options expire unused,” he says. “But analysts should pick up and disclose the reasons for the flip-flops.”
The jury is still be out about the degree to which stock options contributed to recent incidents of fiscal malfeasance and fraud. And it will almost certainly take time until we discover whether the corrective measures — including the push for greater transparency in financial statements, and the creation of a new oversight board for the accounting industry — will actually work.