With so many early stage tech firms using lucrative stock option compensation as a key method of attracting employees and aligning their interests with the investors, the thought of accounting for this by means of a large, additional expense item is cause for great concern. This is particularly alarming with the bottom line already under heavy pressure through the recent slowdown in corporate technology spending. For public companies, it has been reported that the accounting change would reduce estimated earnings per share by 7.4-13% for non tech companies, and up to a whopping 44% for the tech sector, according to reports by the Standard & Poor’s and Bear Stearns.¹

One of the key issues and challenges is educating investors how stock options affect the earnings. The information about stock options is already in the financial statements. The problem is that it is a footnote on the financial statements, rather than a discreet line item.² The S&P announced that they will report earnings for companies by subtracting the footnote options expensing from income. If nothing else, this ever evolving issue prompts discussions on where to properly record the compensation expense and educating employers, employees and investors on how to evaluate the success of their companies.

The Background

In 1995, FASB issues Statement 123 regarding accounting for stock option compensation.³ Previously, stock options granted as compensation, were not reported in a company’s financial statements. However, when options are exercised companies would treat them as a cost, and deduct the difference between the strike price and what they could have received by selling the stock on the open market thus providing many companies with a significant tax advantage.⁴ Under the new method, companies must estimate the “fair value” of the stock option as of the date of grant, and charge that amount as a compensation expense against earnings using one of two complex formulas, Black-Scholes or binomial valuation method, to calculate the fair value. Private companies are permitted to use a simpler method known as the “minimum value” method.

FASB received over 1,700 comment letters sparking a highly contentious debate from a carefully organized, highly orchestrated campaign to prevent the passing of mandatory expensing of stock options.⁵ The resulting compromise issued by FASB was Statement 123, which allowed companies to choose whether to adopt the new proposed fair value method of accounting and deduct option costs from expenses, or stick with the intrinsic methodology and simply disclose them in the footnotes. Not surprisingly, most stuck with the latter to avoid the new expense.

When the corporate scandals hit with reports of massive, fraudulent earnings reporting, it was revealed that some executives in question had received a significant portion of their income by exercising stock options whose values were bolstered by falsified reporting of earnings.⁶ Many public companies began expensing stock options in accordance with FASB as a matter of course in order to demonstrate transparency to their investors. Currently over 750 public companies report stock options as an expense item on their income statement.

In the spring of 2004, FASB took up the issue again and mandated it mandatory to expense stock options. The controversial debate sprung up once again and Congress decided it would throw it’s two cents on the matter. In August 2004, The House of Representatives passed the Stock Option Reform Act stating that only the stock options for the top five executives be expensed and that stock prices never fluctuate which would significantly undervalue those so preciously counted options.⁷ Simultaneously, they also requested a study on the economic impact of broad-based employee stock option plans. This in turn keeps the old rules intact. It defeated the purpose of accountability on the income statement and hence continued to overstated earnings the accounting, quashing the transparency FASB’s Statement 123 was spirited on. The Senate has not officially taken action thus far while many are urging them to do so and kill the issue altogether. Despite the House action, the future of the legislation remains cloudy, as the Senate has shown little interest in overriding the FASB proposal.⁸ Even with Congress’ involvement, FASB’s accounting rules are still considered mandatory and would have gone into effect on June 15th for public companies and December 15th for private companies. However, the SEC commissioner delayed this until Q1 2006 citing concern that companies were already struggling to cope with a new congressionally mandated internal controls reporting requirement.

The Controversy

This heated debate involves politicians, business professionals, accounting boards, high profile investors with many valid points from each side (including top, bottom, and both sides) of the fence. Anyone trying to make decisions about stock option policy should consult their lawyers, accountants and stock/tax professionals.

What the Critics of stock option expensing say:

• Companies do not need another non-cash accrual on the income statement to further cloud an assessment of the quality of a company. Stock options, the argument goes, are non cash payments to employees and not a cost to the company. A company should not have to hold an expense to create trust with shareholders. This should come from good governance policies, and was addressed through the Sarbanes-Oxley Act.⁹
• A powerful tool for recruitment and retention would be lost because executives focused on the bottom line will become stingier in granting options. Stock options were a major driver in the growth of the US technology industry because they allowed companies to reward all employees handsomely for success while, at the same time, preserving precious capital. Specifically with respect to start ups, an award of options is compensating an employee for creating value, not earnings; therefore expensing options on the income statement makes little sense.
• Expensing stock options will lead to more unstable and inaccurate reporting. For example, if an employee leaves a company, never exercising their stock options, the company would have inaccurately reported expenses for prior periods, potentially requiring a costly restatement of earnings – which could be multiplied with each employee termination.
• Expensing stock options is mixing two distinct types of financial statements. Granting an option is offering a share of the business (balance sheet), while the reporting is as an expense on the income statement.¹⁰
• It will raise the tax burden on companies issuing employee stock options. The changes do not end the tax deduction, but require those companies which take the tax deduction to also include the stock options as a cost of doing business.
• The valuation methodology proposed for finding the value of stock options, Black-Scholes and Binomial models, are far from precise and are a cause for more complication. Critics say both are designed to calculate the value of options that are bought and sold in financial markets, not employee stock options, and are flawed models that will yield very different and certainly inaccurate results.¹¹
• The information is already provided and accounted for currently in footnotes. Investors can easily discern the effect of the stock option on the earnings.
• Reducing the attractiveness of stock option compensation will severely stifle US economic growth and its global competitiveness at a crucial time in its position as a global economic leader and innovator.

What the Proponents say:

• Since the stock options have a value they must also have a cost that needs to be reflected against earnings. Stock options are a non cash cost like depreciation.
• Financial statements exist to allow investors to make well informed decisions. Financial statements are not intended to be a sales tool for management. Not recognizing stock options as an expense overstates net income. By not accurately measuring compensation and net income, investors become unable to compare companies with different compensation structures. Expensing options provides a level playing field so that companies that use cash or stock options each have an expense on the income statement. The performance of companies that utilize stock options is overvalued relative to those that pay their employees in cash or other hard assets.¹²
• The showering of executives with outlandish options has lead to fraudulent schemes for bookkeeping involving postponing public revelation of losses.
• Investors are receiving misleading information regarding a company’s true earnings. Currently the information is buried in the footnotes.
• “It is unconscionable that any company would stand up and argue that its ability to attract and reward employees is contingent on its ability to dupe the owners of the company into thinking it is compensating its management and others less than it really is,”¹³ Thomas Bowman stated in a letter to the Senate.
• The International Account Standards Board (IASB) and US Generally Accepted Accounting Principles (GAAP) are increasingly converging their efforts and trying to internationally standardize accounting standards. The IASB encourages expensing.¹⁴

The trick is to strike a balance (no pun intended) between both parties for which many mathematicians have been theorizing and presenting some very creative ideas regarding valuation and reporting. However until then, companies plan to keep abreast of the current requirements and timetables as well as keep their investors and employees well informed.

I’ll leave you with a poll put out by CFO.com last year.¹⁵

What will be your biggest headache concerning FASB’s new proposal that broad-based stock options should be expensed?

• Weighing the binomial and Black-Scholes models
• Explaining the valuation methodology to investors
• Preserving shareholder value once options are expensed
• Hiring top employees if your options plan must change

I would check all four. Once again anyone trying to make decisions about stock option policy should consult their lawyers, accountants and stock/tax professionals on this complex issue.

¹MSNBC Jones, Roland. April 5, 2004. “Stock options may hurt tech profits”. [msnbc.msn.com/id/4648067/print/1/displaymode/1098/]
²CFO.com Schnider, Craig. October 8, 2004. “FASB Refines Stock Option Project”. [www.cfo.com/article.cfm/3281594?f=related.]
³Rave, Michael. “Expensing Stock Options” The Metropolitan Coproate Counsel. September 2002.
⁴Sibelle OPED24 May 25, 2005. “Accounting for Stock Options”. [www.sibelle.info/open24/htm]
⁵PBS Teslik, Sarah. March 2, 2005. Interview with Sarah Teslik, Executive Director of the Council of Institutional Investors. [www.pbs.org/wgbh/pages/frontline/shows/regulation/congress/]
⁶Citizen Works December 2004. “CEO Greed and Stock Options”. [www.citizenworks.org/corp/options/greedoptions.php]
⁷Washington Post Buffet, Warren. July 6, 2004. “Fuzzy Math and Stock Options”. [www.washingtonpost.com/wp-dyn/articles/A29807-2004Jul5.html]
⁸Internet News March 10, 2005. Mark, Roy. “Senate: Stock Option Expensing Likely”. [www.internetnews.com/bus-news/print/php/3489026]
⁹Gressle, Mark and Richard McGinley. “Expensing Stock Options: Fact and Fiction”. February 14, 2005.
¹⁰Gressle, Mark and Richard McGinley. “Expensing Stock Options: Fact and Fiction”. February 14, 2005.
¹¹The Heritage Foundation June 30, 2004. “Expensing Employee Stock Options”. [www.heritage.org/Research/Regulation/reulation_brief063004.cfm]
¹²Politech Bowman, Thomas A. September 14, 2004. “Securities analyst urge Senate for expensing of stock options”. [politechbot.com/2004/09/21/securities-analysts-urge/]
¹³Politech Bowman, Thomas A. September 14, 2004. “Securities analyst urge Senate for expensing of stock options” [politechbot.com/2004/09/21/securities-analysts-urge/]
¹⁴Executive Caliber March 3, 2005. “Expensing Stock Options”. [www.executivecaliber.ws/sys-tmpl/expensingstockoptions/]
¹⁵CFO.com June 2004. “Poll: What will be your biggest headache concerning FASB’s new proposal that broad-based stock options should be expensed?”. [www.cfo.com/article.cfm/3511589?f=search]

-Kate Henriksen