Cover Story
Expensing Options
An Old Debate Rises Again, and the
Outcome Will Impact
the Future of Financial Accounting
BY BEN MATTLIN
Kenneth Broad, co-manager of the $88.7 million Transamerica Premier Growth Opportunities
Fund and Transamerica Premier Focus Fund at Transamerica Investment Management in San Francisco, recalls a former roommate
who worked at Cisco Systems, the communications-gear maker in San Jose. "In his late 30s," says Broad, "he has a $2 million
house he bought with cash from options."
Broad is on a mission to get employee options grants included in corporate accounting not as mere footnotes, as has been
the case for nearly a decade, but in a more prominent place as true expenses. The current system, he insists, is "the most
widespread and legal method of inflating reported results."
If Broad has his way, proposed new regulations from the Financial Accounting Standards Board (FASB), announced in late
March, will become law and put a stop to this. And in an era of intense regulatory scrutiny and strong investor appetite to
clean up accounting improprieties, it seems likely he'll get his wish. Opponents, however, have loud voices and deep pockets
-- loud and deep enough to kill a similar bill in 1994. Can those forces again convince regulators not to rock the boat? Perhaps
more importantly, what do institutional investors need to know to prepare for a battle, which will almost certainly buffet
financial markets?
THE VALUE OF OPTIONS
Speaking of buffet, Berkshire Hathaway chairman Warren Buffett is reputed to have once observed, "If options aren't a form
of compensation, what are they? If compensation isn't an expense, what is? And if expenses shouldn't go into the calculation
of earnings, where in the world should they go?" For some, though, the problem is not so much whether options should be included
as charges against earnings, but how the value of options should be calculated. Up till now, the idea has been that the option
has value only if the underlying stock price rises above the option's strike price before the option expires (typically five
to 10 years). That makes a certain sense. If it happens, the option holder can snag shares at a discount. At the time the
option is given, however, it has no value, say FASB opponents. At best, it merely allows the employee to purchase shares at
the going rate, which of course is no advantage at all.
This reasoning has allowed companies to claim the value of options granted to employees is zero. Though workers receive
them as a form of compensation, they aren't accounted for as an operating expense because they have no cash value when given.
Further, companies incur no cash costs when they grant options to staff.
Yet critics contend options do have value when granted. Options holders not only stand to gain if the stock price swells
but also lose nothing if the stock drops, unlike regular shareholders. Options take much of the risk out of the equation --
and that, advocates of change contend, has real value.
But again, how do you calculate that value? The FASB proposal would allow companies a great deal of latitude in determining
a "fair market value" for options grants. The board prefers, but won't require, the "binomial" or "lattice" pricing model,
which allows various assumptions about the future such as how changes in stock price can influence whether and when employees
choose to cash in their options. All calculation methods must be disclosed. Yet opponents insist this leeway is an invitation
for trouble. "FASB has shirked its responsibility to set an adequate accounting standard," comments Mark Heesen, president
of the National Venture Capital Association, in Arlington, Va. "The numbers companies come up with won't mean a whole lot
at the end of the day."
CHOOSING A PRICING MODEL
Nonetheless, supporters of the FASB plan say as long as that number isn't zero, it doesn't much matter how it's derived.
"Plenty of things on the financial statement are estimated," Broad points out. "Even if it's not a perfect number, companies
need to take a reasonable stab at it." He cites depreciation schedules and loss reserves as inexact accounting items currently
accepted on the books. Still, one options pricing idea Broad supports is that their value is directly proportional to their
life span. "If companies cut back the expiration dates of newly granted options, they are legitimately worth less," he says.
"That's one driver of their value and an easy way to reduce costs."
Other variables in how options are structured can affect their value, too. For instance, many employer-granted options
make the recipient wait several weeks or months before the option can be exercised. Over that "vesting period" the value of
the option could fluctuate with the value of the stock, but FASB's proposal calls for the option's price to be set at the
time it's granted and expensed at that level throughout the vesting period. A shorter vesting period, then, could reduce the
damage done to earnings.
Some companies are reportedly trying options that can only be exercised when the stock price rises 10% from when the option
was given. Others have suggested that certain shares purchased with options should be worth more than others, depending on
how long the employee is required to hold the shares before selling them. Whatever the merits of these and other schemes,
complications are myriad. For instance, what happens when an option recipient is fired or quits? "Most [employee options]
expire within 90 days of the termination of employment," noted Jeremy Bulow and John Shoven of Stanford University, in an
academic paper published this March, "and are forfeited if the employee leaves before vesting." This is problematic, they
suggest, in part because it gives companies an incentive to sack employees who hold "unvested and nearly worthless options."
EFFECTS ON VENTURE CAPITAL
Even harder hit by options expensing than expendable staffers may be young, small companies, which they tend to rely on
options grants to attract talent they can't yet afford, and any addition to the expense side of the equation can be particularly
devastating. "They're going to have to carry this expense even though most of their options may never be exercised," explains
National Venture Capital Association's Heesen. "Many of these companies will go out of business, or their share price won't
get high enough before the options expire."
Proponents, however, counter that venture capitalists and other investors interested in development-stage enterprises understand
that these businesses have a unique need to issue options, and will be forgiving of such charges against earnings. What's
more, the FASB proposal allows companies to delay pricing employee options if the options were granted before the company's
initial public offering (IPO). At the IPO, though, they could face a substantial charge against earnings. "For pre-public
companies, it's a real shot in the dark as to what their options are worth," Heesen contends.
Silicon Valley's technology companies -- the startups of yesterday -- are expected to bear the brunt of new options-accounting
rules. Even those that are now well established continue to rely on options-based incentives, and few ascribe them any cash
value. Pat McConnell, an accounting analyst at Bear Stearns, estimates that the top 100 companies listed on the Nasdaq would
have reported 44% lower aggregate net income from continuing operations in 2003 if they'd followed the proposed FASB guidelines.
By comparison, companies listed in the broader Standard & Poor's 500 (S&P 500) index would only have eight percent
less in aggregate net income for 2003 if they had expensed options.
ANTICIPATING CHANGE
In fairness, that's partly because approximately one-fifth of the S&P 500 already does expense options. Additionally,
many have curtailed giving options in anticipation of new regulations. David Zion, an accounting analyst at Credit Suisse
First Boston, notes that the S&P 500 would have had 19% and 20% lower aggregate earnings in 2002 and 2001, respectively,
if options were expensed in those years. Even so, as many as 29 S&P 500 companies would have seen earnings plummet by
more than 50% in 2003 if FASB standards had been enforced. Included on that list are such non-technology companies as executive
recruiter Robert Half International, copper producer Phelps Dodge Corp. and forestry products maker Boise Cascade Corp., all
of which would have had to report an operating loss if they expensed options.
These changes don't come without considerable warning. In 1972, what was then called the Accounting Principles Board pushed
for options to be valued as the difference between the underlying stock's price when the option is granted and the exercise
price of the option. In most cases, the exercise price was the current price at the time the option was granted. This undoubtedly
contributed to the notion that an option's value is zero. But a year later, the Black-Scholes model for calculating the value
of options was advanced. Still in widespread use, it relies on assumptions about interest rates, stock volatility and other
economic variables to pin a fair price on options.
In the early 1990s, the renamed FASB attempted to pass a regulation nearly identical to the one currently in process, but
the U.S. Senate voted it down in 1994. Ultimately FASB could only recommend, not require, the fair expensing of options.
After that regulatory defeat, options granting surged in the bull market of the late 1990s. The number of employees who
received options as part of their compensation grew from under one million in 1990 to some 10 million in 2000, as measured
by the National Center for Employee Ownership and quoted in the Harvard Business Review ("For the Last Time: Stock
Options are an Expense," by Zvi Bodie, Robert Kaplan and Robert Merton, March 2003). "The use of options has ramped considerably
in recent years," attests Broad of Transamerica. "There are many cases of egregious misuse."
FULL DISCLOSURE
Broad is optimistic that FASB standards will become law this time. Recently, shareholders of Palo Alto, Calif., computer
maker Hewlett-Packard Co. and Pleasanton, Calif., software developer PeopleSoft have voted to implement options expensing,
reportedly against management's wishes. Next year, the International Accounting Standards Board is expected to implement a
similar expensing rule for the European Union, Australia and elsewhere. "The bursting of the tech bubble and all the accounting
scandals have created a huge appetite for good corporate governance and full disclosure," says Broad.
But is options expensing truly a matter of full disclosure? Since the 1995 compromise between FASB and Congress, companies
that chose not to subtract options grants from net income had to report them elsewhere, usually in financial footnotes. "Options
compensation has been disclosed for years," says Michael Reznick, a consultant at Frederic W. Cook & Co., an independent
executive-compensation advisor in New York. "Investors and analysts who care about this expense were already including it.
And those who don't think it's important can easily reverse it out after it's required."
Ironically, critics and supporters of the proposed change agree that such second-guessing and refiguring of results could
cause more confusion, not less. "The idea that the marketplace will simply discount these things is ridiculous," says Heesen,
of National Venture Capital Association. "If people start looking at two different sets of numbers, it creates more pro forma-type
accounting. This is exactly what FASB is supposedly fighting against."
MARKET IMPACT
Mike Thompson, director of research at Thomson Financial, compares the options expensing debate to the introduction of
Generally Accepted Accounting Principles (GAAP) standards for international companies some 15 years ago. "Many foreign-based
companies realized that the only way to attract the American investor was to adopt GAAP standards," he recalls, "and liquidity
picked up." The moral of the story: "The more transparency companies provide, the better the liquidity of their shares," he
says, adding, "Too much transparency into compensation structure, on the other hand, might not enhance the value of shares
long term."
Certainly if reported earnings drop by 40% or more overnight simply because of subtracting a higher amount for options,
investors could flee in droves. "It will be problematic for financial statement comparability year-over-year," acknowledges
Reznick. "But that will work itself out in time."
The whole notion of historical options pricing adds another element. The FASB proposal calls for options granted years
ago but not yet vested--that is, not yet tradable for shares -- to be expensed along with new issues. The amount would be
determined by the value when the option was granted, whether or not it's actually worth more or less now. Even companies that
have stopped issuing new options might have to "account for old grants for consistency's sake," says CSFB's David Zion. "Depending
on how much negative feedback FASB receives, however, there's the potential this transition approach could change."
How much investors will care about past options remains to be seen. A recent Thomson Financial study indicates that shares
of companies that already expense options don't necessarily fare any better or worse than others. "The market will only look
at the go-forward numbers," holds Broad.
Nevertheless, the debate will go on. "Opponents of expensing have long argued that there is no meaningful way to value
employee options, and that any attempt to do so will distort or destroy the comparability of income statements," says Zvi
Bodie, finance professor at Boston University School of Management. FASB, he maintains, is "simply requiring that companies
reflect the cost of employee compensation. It is not taking a position on whether or not companies should issue options...The fair
value of the option can be measured at least as accurately as many other items."
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