Expensing stock options is one of the many accounting issues that gained urgency in the wake of Enron, WorldCom and other corporate scandals, where it was revealed that senior executives were pocketing millions of dollars from cashing in hefty option packages. Investors were now hip to senior executives who mischievously inflated stock prices in order to increase the amount of cash they would earn when exercising their options.
The consensus today is that investors want to know more about these options and the expense they incur. Nearly 68 percent of institutional investors want to see options expensed, according to a recent survey by Thomson Financial of around 40 buy-side portfolio managers and analysts.
Where would they like to see those expenses reflected? Over 80 percent of analysts and portfolio managers would like to see stock options expensed on the income statement, according to a November 2001 survey of Association of Investment Management & Research (AIMR) members. ‘We have reason to believe that number is still reflective of our members today,’ notes Rebecca Todd McEnally, vice president of advocacy at AIMR.
Coca-Cola beat everyone to the punch in realizing that companies would benefit by voluntarily deciding to expense options. In early July 2002, the company boldly announced it would begin expensing options in the fourth quarter of 2002. The Washington Post Co, Bank One, General Electric, Amazon.com and Computer Associates followed suit with similar announcements and today over 100 US companies have decided to start expensing options. At the same time, technology heavyweights like Microsoft, Intel and Cisco announced that they would not expense options. Why? Critics say it’s because expensing options would cut too deeply into their income.
Changing the rules
Meanwhile, accounting standard setters have been working on guidelines for expensing options. In November 2002, the International Accounting Standards Board (IASB) released an exposure draft on expensing options following the fair valuation method.
In the same month, the Financial Accounting Standards Board (FASB) put out a draft exposure on accounting for stock options also endorsing the fair valuation method of reporting stock options and promoting quarterly disclosure of the cost of stock options. The timeline for these rules is tight. FASB plans on amending current regulations (under FAS Statement 123) by the end of 2002; and the IASB will likely come out with a final draft in the first quarter of 2003 with a final rule expected in January 2004.
In their present form the IASB and FASB draft exposures are similar on many levels. They both address key issues like the repricing and cancellation of options. Their differences are relatively minor, according to James Leisenring, who is an IASB board member. ‘FASB treats a very esoteric accounting issue differently, which is the income tax effective options,’ he points out. ‘And unlike the IASB’s exposure draft, FASB would reverse options that never vest. In other words, if you start out expensing options and after four years somebody quits before they vest, they would reverse all that compensation and say that nothing ever happened.’
The goal of the IASB and FASB is to come up with a single model that companies around the world will use to expense their options. Leisenring expects the final rule will be somewhere between what the IASB and FASB are now proposing. So, on the surface, it looks as if companies will have clear guidelines to follow when figuring out how to account for stock options. However, neither accounting body is endorsing a particular method for calculating option expenses. ‘Neither the IASB nor the FASB specify which model should be used when accounting for stock options,’ says Leisenring.
And therein lies the rub. Accounting experts agree that expensing stock options on the income statement is necessary to increase accounting transparency. However, they do not endorse one calculation model as best reflecting the cost of options.
Reporting on options today
As it stands today, companies reporting under Gaap can use either the intrinsic value method or the fair value method of reporting options. Under the intrinsic value method, a company expenses the difference between the share price on the day of issue and the exercise price of the option. Since the difference between the exercise price and the share price is often zero, there is usually nothing to expense under this model.
Using the fair valuation method, options are expensed into income-based on an option-pricing model like Black-Scholes. This model looks at a number of factors including the share price, the option strike price, volatility, dividend and the vesting period. The option value is amortized over the vesting period of the option and charged to personnel expense. For obvious reasons, most companies follow the intrinsic method.
What is ironic, suggests AIMR’s McEnally, is that many companies use the Black-Scholes model when deciding how many options to grant but then resort to the intrinsic value method when reporting on options in financial statements. ‘Our concern is that a major cost of operations, especially high-tech companies, doesn’t get recorded on the income statement,’ says McEnally. ‘All analysts see is a share buyback and then promptly the share would be reissued and the effect on the outstanding number of shares would be small, if any.’
Even under current accounting, investors can calculate the effect of stock options on income. In 1995, FASB ruled that companies had to report the cost of options in their footnotes. ‘There are footnotes to the income statement that indicate what the expense would be and its effect on earnings per share,’ says Blaire Jones, senior vice president at human capital consulting firm Sibson Consulting.
Layman’s numbers
Companies know that investors don’t want to go searching in the footnotes, however. The push to expense options is part of a drive towards greater transparency that is similar to the plain English initiative: it’s about putting numbers in layman’s terms. From an IR standpoint, it makes sense to expense options in the same way it makes sense to nominate new, independent board members. It is all part of restoring investor trust in capital markets.
GE and Computer Associates (CA) were among the first companies to announce they were going to expense stock options on the income statement. ‘We had been disclosing the effect [of options] on a pro-forma basis in our annual reports as the regulations permitted,’ notes David Frail, director of financial communications at GE. ‘However, investors clearly wanted the expenses to count and we made the decision to do so.’
CA, which is currently under investigation by the SEC for allegedly shifting revenue, felt a push from certain institutions that believe options should be looked at as an expense. ‘A lot of institutions already had put in their models to come up with some type of charge for stock options, so it wasn’t a hard sell,’ notes Bob Cirabisi, CA’s head of investor relations. Both GE and CA announced the decision to expense stock options in the context of several other corporate governance changes.
With the exception of Amazon.com, it’s the companies whose income is least impacted by expensing options that are coming forward and deciding to expense. GE and CA, for example, do not have hefty, broad-based option packages. ‘Going back in history, [the option grants] have been in the range of less than 1 percent of outstanding shares,’ notes Cirabisi. ‘We have one of the lowest levels percentage wise of most technology companies.’ For its part, little more than 10 percent or around 40,000 of GE’s employees have option packages, notes Frail.
GE and CA are both using the Black-Scholes model to calculate the value of stock options but neither company feels particularly good about it. ‘There is no perfect method for valuing stock options but at least the Black-Scholes method is fairly well understood,’ notes Frail. ‘We understand its limitations as well. The tools and measurement are imperfect but we have the clear sense from investors that they want the expenses to count.’ Cirabisi agrees. ‘At this time, until there is a better method or more well-known method, we will continue to use the Black-Scholes model,’ he adds.
Accounting experts also think the Black-Scholes model leaves something to be desired. ‘Black-Scholes is a measure of value, not of cost,’ suggests Sibson Consulting’s Jones. ‘It predicts what an option might be worth versus what it costs the company. Research has shown it not to be a good predictor of actual stock option outcomes and it was never intended to be that.’ Jones cites a study recently conducted by Sibson Consulting showing that the Black-Scholes model predicted the actual gains in stock prices only 5 percent of the time in looking at S&P 500 companies over a 20-year period.
The bottom line
Currently there is no consensus from the institutional community in terms of which model best reflects the value of stock options, notes David Drake, managing director of Georgeson Shareholder Communications. ‘The question for companies isn’t whether they are using Black-Scholes, it’s whether there is an accurate way to reflect the cost of the option – and nobody has developed that yet,’ he adds.
Mark Utting, CFA, suggests that to begin with, companies should provide investors with more information about stock options in the notes on financial statements or MD&A (in the case of 10Ks). The bottom line, says Utting, is this: ‘You don’t need to get into a lot of detail to provide investors with what they want to know about stock options. They want to know that options are not a get-rich-quick scheme [for senior executives] and they want to know what the potential dilutive impact would be.’
