Consider the Pros and Cons of Expensing Stock Options

Thinking twice about FASB's proposed standard

Charles J. McPeak, MBA, CPA

The popular position of “expensing stock options” may not be a panacea to corporate governance.

In the following issue of GBR (Vol 6, No. 1) Professor Steve Ferraro argues for the opposing view that options should be expensed. To read that side of the argument go to "Recognize the True Cost of Compensation: Expensing options increases transparency in financial reporting."

In the post-Enron era it has become very popular to propose the requirement that companies record an expense at the time a stock option is awarded. The author has closely followed the Financial Accounting Standards Board’s actions related to this subject since 1991 and has consistently taken the minority position that holds that expensing is NOT appropriate.

There are two issues surrounding the recording of an expense when an option is awarded:

Does the expensing provide a level playing field in accounting for management compensation?
Would the recording of an expense when an option is awarded improve corporate governance?

Background

In 1991 the Financial Accounting Standards Board (FASB) floated a draft of a proposed new accounting standard. FASB indicated that a level playing field did not exist in the reporting of management incentive compensation. Companies that rewarded management with cash bonuses were required to report a compensation expense for the amount of the bonus paid, thereby reducing net income. In contrast, FASB stated, companies that rewarded management with stock options did not have a comparable reduction in net income. FASB’s proposal was that, at the time a company awarded a stock option to an employee, it record an expense for the “fair value of the option”.

The method of calculation was not to be mandated. However, the method most often suggested since 1991 has been the Black-Scholes Option Pricing Model. This Model was developed in 1973 and consists of a set of algebraic equations. It has been used by many option traders. In essence, FASB was saying that, if the company sold the option in the public market, it would receive a cash payment from the buyer. By giving the option to the employee, the company was foregoing the cash it would receive if it sold the option. The “fair value” of the option, as determined by the Black-Scholes Model, or some other valuation model, should therefore be recorded as an expense.

Subsequent to the floating of the draft proposal by FASB in 1991, many hi-tech companies voiced strong objection. These companies argued that employee stock options were the primary incentive they had to recruit technology professionals and to motivate various levels of employees. The opposition by technology companies did not immediately influence FASB, and the development of a proposed standard requiring expensing continued. At that point hi-tech companies began contacting their Congressional representatives. Many members of Congress sided with the hi-tech companies and moved to have FASB back off on FASB Statement 123. When FASB failed to bend, members of Congress took an extremely aggressive posture on this matter -- to the point that the existence of FASB as an independent standard setter was threatened. In repose to this threat, FASB Statement 123 was revised to require only footnote disclosure of the pro forma effect on net income and earnings per share if an expense had been recorded.

Recent Events

In the post-Enron era, FASB’s early 1990’s posture on the “expensing of stock options” has been resurrected. The concept of a level playing field has been supplemented with a new rationale for recording the expense. This rationale starts with the premise that companies such as Enron, Global Crossing, and WorldCom used accounting treatments that were improper and unethical in order to inflate net income and earnings per share. These company executives were motivated to increase the stock price because it would be financially rewarding to the management since they held substantial options on the stock. If the companies had been required to record an expense at the time the option was granted, they would not have been so generous with the options. By curtailing the options, the incentive to inflate net income and earning per share would have been reduced.

Pros and Cons Oof "Expensing Stock Options"

Several arguments have been made, both pro and con, regarding this issue. Following is a summary of the key arguments on both sides.

Pros

Expensing options will provide a level playing field so that companies that use cash bonuses and companies that use stock options each have an expense on the income statement.
It will improve corporate governance by reducing or eliminating incentives to inflate income and earnings per share.

Cons

The playing field is already level. A company using cash bonuses as management incentive compensation has a reduction in net income and a resultant reduction in earnings per share. When a stock option has been awarded and the strike price is in the money, the additional shares become outstanding for purposes of calculating earnings per share. Since earnings per share is calculated by dividing net income by weighted average shares outstanding, as the shares outstanding increase, the earnings per share decrease. To require a company to record an expense for the option, and subsequently increase the shares outstanding is a double hit to earnings per share.

Regarding improved corporate governance, it is difficult to believe that the management or the Board of Directors of Enron would have limited the number of options simply because of the requirement to record an expense. Management that is truly unscrupulous is concerned strictly about personal gain and not about the company’s income statement.
During recent years, each time that earnings management is scrutinized, analysts regularly state, “follow the cash.” Ignore entries that are purely accounting and have no cash impact. Such is the nature of recording an expense when an option is awarded. This is an accounting entry with no cash impact. It is very likely that analysts will remove the option expense from the income statement to obtain a clear view of the company’s performance. This would likely lead to companies including a pro forma income statement which excluded the option expense.
As a footnote to the “follow the cash” guideline, it is interesting to note that, not only is there no cash impact from the expense option, there is positive cash flow to the company. At the time the option is exercised, the employee must pay for the shares received.
Hi-tech companies have traditionally issued options to multiple levels of employees with two purposes in mind: attract high quality employees to the company; and motivate workers at all levels. If hi-tech companies were required to record an expense at the time options are granted, many employees at all levels would most likely lose the options.

Conclusion

With regard to FASB’s original position, there appears to be no reason to make the proposed change in order to provide a level playing field.

As to the improved corporate governance argument for the change, the Securities and Exchange Commission certainly has just cause to seek improvements in corporate governance. However, there are ways of accomplishing this without creating controversial accounting requirements and penalizing employees below the top level of management. There are more effective ways to accomplish this than the FASB proposal on expensing options.

Two suggested methods of dealing with options that could improve corporate governance are:

The SEC could place a limit on the percentage of a company’s options that could be issued to the top three people in the company.
The SEC could require that the top three people in the company be issued options on restricted stock (often called “letter stock” or Rule 141 stock). This stock must be held for two years before it can be sold.

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For additional views on the subject of expensing stock options, please refer to the following Wall Street Journal articles:

“The Real Value of Options," Harvey Golub, August 8, 2002

“The Options-Accounting Sideshow,” Robert L. Bartley, July 29, 2002

To doublecheck your understanding of options, try our ONLINE OPTIONS QUIZ.