Recognize the True Cost of Compensation

Expensing options increases transparency in financial reporting

2003 Volume 6 Issue 1

Compensation options are a cost to the firm and need to be expensed if financial statements are to reflect the true value of the firm.

In the previous issue of GBR Professor Chuck McPeak argued for the position that expensing compensation options is an improper accounting procedure and inaccurately attributes costs to the firm that are actually born by the shareholders through dilution of their shares. (Consider the Pros and Cons of Expensing Stock Options.) In the article below Professor Steve Ferraro presents the other side of the argument.

The Crux of the Problem

A financial analyst/money manager recently asserted that over the last two decades the U.S. has witnessed the greatest transfer of wealth in its history. He didn’t cite exact figures, but reported that in 1980 insiders and executives of publicly traded firms owned approximately 3 – 4 percent of the equity in these publicly traded firms. By 2000 their proportion of ownership had increased to approximately 10 -12 percent. Consistent with this observation, CBS.MarketWatch.com reports that in 1960 executives earned about twelve times the wages of the average employee. In 2000, the estimate is 531 times.[1]

A related observation can be made about actions at the firm level. Under somewhat optimistic assumptions, the value of Jack Welch’s GE stock options could reach $1 billion by the year 2010 if GE stock continues to climb at the same average rate of growth it experienced over the last ten years.[2] However, according to GE’s financial reports, the options were costless to the firm and its shareholders. And herein lies the problem. When it comes to the cost of compensation options, the lack of transparency has become the focus of a hotly debated issue.

At the time of the GE analysis, options with an 18-month maturity were traded at $6.90. Using this figure as a proxy for the value of Jack Welch’s stock options, the market value of all the options given to Welch is approximately $20 million. But you won’t find an equivalent expense on the income statement anywhere. Why not? Because that $20 million is considered to be an opportunity cost, not a cash expense. That is, if the firm had sold the options in the open market, it would have received $20 million in proceeds and the proceeds would have been recorded because cash was involved. However, because no cash is received when options are issued as compensation, they are not considered to have any value and are not expensed.

An economic perspective recognizes the market value of the options and necessitates an accounting of the expense. The $20 million in the GE example may not seem like much to argue about, but for other firms, expensing options can turn a solid accounting profit into a loss. For example, eBay’s 2001 accounting profit was $90.4 million. However, after incorporating the value of the compensation options, the profit turns into a loss of $14.5 million. That’s more than a $100 million dollar difference.[3] Moreover, Merrill Lynch estimates that expensing options would reduce the S&P 500’s average earnings by 10 percent.[4] Analysts at Sanford C. Bernstein estimate that for high-tech companies the options expense was equivalent to 51 percent of operating earnings in 1999.[5]

Arguments Against Expensing Options — and Rebuttal

In reviewing the ongoing debate about whether or not to expense options, the following seem to be representative of the arguments presented for not expensing the cost of stock options. They are presented one at a time for a closer look.

1) There are no clear standards for options valuation, and valuing options requires forecasting the future and is a subjective.

The two most common methods of option valuation are the Black-Scholes Option Pricing Model (BSOPM) and the Binomial Option Pricing Model (BOPM). It has been reported that approximately 90 percent of U.S. firms are currently using the Black-Scholes model, or some variation of it, to value non-marketable options. Most others use the binomial option pricing model.[6] These methods typically give option values that are within pennies of one another. Moreover, firms use these option pricing models to determine how many options should be included in an executive’s pay package. If the option pricing models are good enough to determine executive pay, why aren’t they good enough to account for those same options?

The models each require the user to forecast the future, and the models’ output can be sensitive to the input assumptions. But many of the input variables are readily available in the market or are known (e.g. the firm’s stock price, the risk-free rate, the time to maturity) and do not need to be estimated. The market has already done the estimation. In addition, financial managers make a living forecasting the future. To value an acquisition candidate, the target firm’s future cash flows are estimated. To determine the quality of a bank’s loan portfolio, the number of bad loans must be determined based on expectations of the future (and perhaps outcomes of the past). Cash management requires the estimation of collection risk. Bond rating agencies have to estimate credit risk. The examples of estimating the future are myriad, so it serves no point to go on and on. Basically this argument boils down to, “Forecasting the future is a difficult and imprecise exercise, and the tools we have are less than perfect.” But this is true for most valuation issues, including placing a value on a stock, which the market does every trading day, all day long.

2) Options expensing exaggerates the true cost of options.

This argument points to some potential problems with the underlying assumptions of option pricing models. The BSOPM was developed under the assumptions that the options being valued are of short maturity and that there is a liquid market for them. Options issued as compensation typically have five – to ten -year maturities and little or no liquidity. Thus the argument is that option pricing models are ill-suited for valuing options issued as compensation. However, there are numerous non-liquid markets where assets and securities trade. For example, private businesses are bought and sold in such markets. Debt and equity securities trade in the private placement market as well. The market’s solution for lack of liquidity is to discount the price of the asset or security to reflect the lack of liquidity. The same can be done for options issued as compensation.

Another version of this protest is that the cost of the option is already taken into account by diluting the earnings per share (EPS), so expensing those options would “double count” the cost.[7] When considering EPS, it is worth noting that the numerator, that is earnings, is unaffected by the dilution resulting from the issuance of additional shares in fulfillment of the compensation contract. An economic perspective would suggest that the value of the options should be reflected in the compensation costs as well as in ownership dilution, thus reducing earnings in that period. There is no double counting here. The market value is the immediate cost, reflected in the earnings stream, and the dilution is a long-term cost due to sharing the benefits of ownership with more owners.

Finally, a third version of the argument is that if the options finish out-of-the-money or if an employee leaves without being able to claim the value in the options, then the options really don’t cost the firm anything.[8] But the true economic cost is determined when the options are issued, and that is when firms should recognize their value. The fact that options were not exercised does not mean they had no value when they were given as compensation.

3) Expensing options would create a need to continually recalculate the value assigned to those options, and previous quarters’ earnings would have to be recalculated, thereby compounding investor confusion.

There is no need to revise the original option value estimates once the options are issued. It is true that option values will change over time, just as the values of all assets change over time. But there is no need to revise those values unless the board decides to change some of the options’ characteristics (i.e. recontract), such as lowering the exercise price. Of course, best practices of corporate governance in the current market environment would suggest that rewriting the old contracts is suboptimal and should be avoided. If compensation options finish out-of-the-money, the managers did not create sufficient value for shareholders to be awarded additional compensation. Issue new options and move on. Better yet, the original options can be contingency-based, with floating strike prices to account for some of the identifiable uncertainty or risk that cannot be properly hedged or is out of the control of management. And yes, current option pricing models can handle these complex contracts.

It should be noted here that executives have identified another loophole in the FASB standards and another way to manipulate earnings estimates. Under the current standards a firm can cancel out-of-the-money options, wait for six months and one day, and issue replacement options with lower strike prices without having to report the cost of the new options. Technically this action doesn’t count as repricing. Economically it does, and it imposes real economic costs on the firm and its shareholders. To date Sprint, Inktomi, Commerce One and Real Networks, among others, have all taken advantage of the six months and one day loophole.

4) Expensing options creates another means for managers to manipulate earnings.

This is an accurate observation. Mangers can manipulate their firm’s earnings streams by playing games with the estimates of the inputs used in valuing options. But the focus of the argument is misdirected. Managers are already manipulating their firm’s earnings streams by not recognizing the economic cost of the options being issued to employees. In commenting on earnings manipulation, Jeff Skilling, the disgraced former CFO of Enron, testified to a Senate committee: “The most egregious [method], or the one that is used by every corporation in the world, is executive stock options. Essentially what you do is, you issue stock options to reduce compensation expense and therefore increase your profitability.”[9]

Since options have real economic value, ignoring this value results in firms underestimating the true compensation of employees and reporting inflated earnings estimates. By recognizing the costs of the options, managers will reduce this underestimation of true compensation costs and overestimation of earnings. Room for manipulation will still exist, but the exaggeration in the earnings figures should be reduced.

5) The only problem with options is the way the option schemes have been designed to provide excessive executive compensation.

The market seems to agree that the design of executive compensation packages has been, and still is, very flawed. But the design problem’s roots run deep into the misunderstanding of how to value options. First, under current accounting rules, options are costless to the firm. From this perspective, it matters little whether the firm awards an option on one million shares or five million. The “cost” to the firm in an accounting sense is the same – nothing. But the dilutive effect in awarding an option on five million shares is five times as great, as is the opportunity cost. Thus, not knowing the true value or cost of the options being given can lead to payouts never intended by the compensation committee.

Second, there is a misunderstanding of the relationship between risk and the value of options. When a firm’s future is highly uncertain, some will argue that mangers should be given more options to ensure that there is some future payoff for the hard-working executives. However, the higher the uncertainty (or volatility in options parlance), the more valuable the option becomes. This is reflected in the options pricing models. That is, when a firm’s future is highly uncertain, it should be giving out fewer options, not more, because each option is going to be more valuable than it would otherwise be with a relatively certain future.

As a result of this flawed understanding, executives are awarded too many options, Such options help cushion the downside on their compensation if the firm underperforms expectations and grossly over-reward them if the firm outperforms expectations. Either way, executives have hedged their bets and, on average, may be paid too much regardless of the firm’s performance.

6) Firms that rely on significant managerial compensation in the form of options are unfairly penalized.

In 1993, Silicon Valley executives successfully thwarted FASB’s push to have the value of options expensed, largely based on arguments like this one.[10] High tech firms would feel punished for having to recognize the entire cost of their human capital. And this is where their argument gets interesting. These firms argue that they need the best and brightest to make the firm competitive and successful. But the best and the brightest cost the most and the only way for them to be fairly compensated is through stock options. Fair enough; that is the way a well-functioning labor market should work. However, when it comes to reporting the costs of the human capital, these firms want to pretend that their labor is no more expensive, and often less expensive, than it is in other parts of the economy.

From an economic perspective, this argument is not sound. The cost is what it is, and if the firm has viable technology and can convey its story in a credible and convincing manner, the market will reward it and its employees. If it doesn’t, then the firm will have a difficult time attracting labor and capital.

7) Only cash flow matters. Since there is no cash involved in issuing compensation options, analysts won’t consider the value of options anyway.

It is true that if you open a finance textbook, you will find that an essential step in valuation is to determine the cash flow. Since there is no cash outflow to the firm when it issues options, the cost of the options won’t show up in a cash flow estimate. However, savvy practitioners are much more sophisticated than to accept this as reflecting reality. To illustrate the point, Standard & Poor’s has begun reporting what they call “core earnings” which include the cost of options used for compensation. Institutional investors such as TIAA-CREF and CALPERS are now requesting firms in their portfolios to include the cost of compensation options in reported earnings. And the well-respected Warren Buffet has convinced several of the firms he is associated with to expense the cost of compensation options. Finally, 83 percent of professional money managers, brokers, and equity and fixed income analysts surveyed by AIMR (Association for Investment Management and Research) have agreed that options are a form of compensation and should be expensed.[11]

Make no mistake; the market is paying attention to the cost of these options when making investment decisions whether they show up on the income statement or not. Nevertheless, there are day-traders and other less-sophisticated investors who spend more time investigating refrigerators before they buy one than they do investigating a stock before they buy it, to paraphrase Peter Lynch. It is precisely those unsophisticated investors who need additional information, presented in its most transparent form, according to Arthur Levitt, former chairman of the SEC.[12] Investors want more transparency. The question is; does management?

Conclusion

The economic perspective on firm performance and value demands that the cost of compensation options be estimated and recognized as an expense. However, the idea of accounting for opportunity costs is problematic for our current accounting system and will cause some growing pains as it evolves into a structure that provides more transparency to investors and enables the market to better understand the underlying economics of the firm. Three well-regarded accountants have stated that the purpose of our accounting system is to “measure and report the economic consequences of business activities.”[13] Currently it doesn’t do this as well as it could, but we seem to be headed in the right direction with the move toward expensing compensation options.


[1] Bambi Francisco, “Can Justice Be Served?” Commentary: When Execs Disgorge or Share the Wealth, CBS.MarketWatch.com,, October 15, 2002.

[2] Justin Fox, “The Amazing Stock Option Sleight of Hand: Justin Fox Exposed Corporate America’s Grandest Illusion,” Fortune Magazine, June 25, 2002.

[3] Timothy J. Mullaney, “Options: Clearing the Fog for Investors,” Business Week, September 23, 2002.

[4] Todd Jatras, “Expensing Options,” Forbes, July 24, 2002.

[5] Fox, 2002

[6] Joan Harrison, “Challenges for Companies Valuing Options,”Mergers & Acquisitions, Nov. 2002

[7] Charles J. McPeak, “Consider Pros and Cons of Expensing Stock Options: Thinking Twice about FASB’s Proposal,” Graziadio Business Review, Vol. 5, No 4, 2002.

[8] Alvo Svaldi, “Stock-options Switch Getting Cold Shoulder from Companies: No Clear Standard for Expensing,” Denver Post, July 28, 2002.

[9] Justin Fox, “The Only Option (for Stock Options, That Is): Pretending They Are Free Didn’t Work,” Fortune Magazine, August 12, 2002.

[10] McPeak, 2002.

[11] Anonymous, “AIMR’s Stock Option Survey, AIMR Advocate, January/February 2002, 7 (1).

[12] Arthur Levitt, Take On the Street, New York: Pantheon 2002.

[13] Krishna G. Palepu, Paul M Healy, and Victor L. Benard, Business Analysis and Valuation: Using Financial Statements, 2nd ed., Mason, OH: South-Western College Publishing -2002, p. 1 – 4

About the Author(s)

Steven R. Ferraro, CFA, PhD, is an associate professor of finance at Pepperdine's Graziadio School of Business and Management where he teaches corporate finance, valuation and corporate combinations, and investments. His current research interests include corporate restructuring, event-driven investing, and real estate investment trusts. Dr. Ferraro is managing director of the Center for Valuation Studies and principal of Ferraro Capital Management. He holds a PhD from Louisiana State University and is a Chartered Financial Analyst (CFA). He is also a recent recipient of the Howard A. White teaching award.

Comments

DAISI FUNMI

November 4, 2011 at 4:39 am

Writing project on the “THE EFFECT OF COMPENSATION ON BEHAVIORAL PATTERNS OF EMPLOYEES AT WORK IN SELECTED ORGANIZATIONS” how can you please help.

Looking forward to your favourable reply.

Regards,

daisi