In July Microsoft shocked the corporate world by announcing a decision not only to expense stock options but also restate past financial statements to show how stock options were affecting the bottom line. Expensing options is one thing, but volunteering to restate past financial statements to show stock options as an expense on the income statement – that’s another matter entirely.
The other major surprise: Microsoft struck a deal with JP Morgan Chase to give employees, many of whom hold underwater options, the chance to sell their options to the bank for cash. JPMorgan will make money on the spread between what it pays for the options and what they ultimately are worth. The deal has yet to be cleared by the Securities and Exchange Commission (SEC), however.
‘We chose an accounting path that would give our investors the best visibility into the program,’ says Curt Anderson, Microsoft’s director of IR. ‘As for the option exchange program, there are still some hurdles we are waiting to clear as we’re working on some regulatory matters and still finalizing the terms.’
Institutional cheers
Investors, including those more scrutinizing ‘activists’ who have traditionally focused on corporate governance, are applauding Microsoft’s decision. In fact, institutional investors say the deal with JPMorgan supports the argument that stock options should be treated as an expense on the income statement.
‘Basically the deal shows that even underwater options have value,’ comments Peter Clapman, senior vice president and chief counsel for corporate governance at pension fund giant TIAA-Cref. ‘That’s a common sense evaluation, but it’s one that many high techs have been disputing for years.’
Clapman says Microsoft’s announcement will hopefully help isolate firms that stick to fixed-price options and ignore the fact that accounting regulators in the US and Europe are going to require this form of compensation to be expensed. ‘We encourage companies to move proactively and follow Microsoft’s lead,’ he says.
In an ideal world, Clapman would like to see companies reducing their overhang (the percentage of all shares outstanding that all outstanding options would represent if executed) by buying back the shares rather than allowing employees to sell them as Microsoft did.
But he’s not complaining: ‘We’re strongly supportive on the whole of what Microsoft did, and if they felt to do it the right way required all those elements they’ve announced, we’re not going to quibble,’ Clapman says.
To expense or not
A flood of companies following Microsoft’s lead has yet to materialize. But Barry Zwarenstein, CFO and vice president of finance and information technology at California-based Iomega, points out that every company needs to weigh the pros and cons when it comes to expensing options. For Iomega, that thought process led the company to voluntarily expense all options granted after January 1, 2003 but not restate past financial statements. One reason it didn’t want to restate prior financial statements was the company had recently switched auditors, thus complicating the restatement process.
‘Frankly, the decision to begin voluntarily expensing options was driven by the culture here, which is extremely focused on good corporate governance,’ says Zwarenstein. ‘We recognize there are arguments over how to value employee stock options, but we fell into the camp that if it’s not an expense then what is it?’
Iomega follows the ‘prospective’ method of expensing options, treating the current year’s options as an expense but ignoring past option grants. ‘Unlike many tech companies, we have not been that aggressive with options,’ notes Zwarenstein. ‘Our overhang is just 5 percent versus overhangs in the teens for many others in Silicon Valley.’
What’s ahead?
Pretty soon companies around the world won’t have any choice but to expense the cost of option grants because accounting rule-makers in the US and Europe are working to come up with new guidelines for expensing options.
In the US, the big debate is not over whether companies should expense options, it’s how they should expense them. The Financial Accounting Standards Board (FASB) is currently working on a project that will require US companies to expense the cost of employee options and is mulling over which accounting method to endorse for expensing options.
The accounting standard-setter has been pushing companies to expense options for over a decade. ‘In the 1990s FASB worked to require that companies automatically expense stock options in the income statement,’ explains FASB spokesperson Sheryl Thompson. ‘Unfortunately the proposal was met with tremendous opposition and was killed in Congress. Then you had Enron and WorldCom and a series of other accounting disasters. There was a cry for reform from investors, and one of those cries was for better stock options accounting. In March 2003 we said options should be treated as an expense on the income statement and set up a project to accomplish this.’
In anticipation of a new rule requiring expensing, FASB published guidance in December 2002 which provides companies with three methods for voluntarily expensing options. The method most companies have followed is the prospective approach but FASB also proposed a second method whereby the current year’s expenses include both newly granted and previously granted options, which results in a bigger hit to current earnings but has no impact on past results. The third method, referred to as ‘restatement’, requires companies to restate prior years’ results to account for previously granted options as an expense in the years they were granted.
‘Next year they’ll just have one method,’ says Thompson. ‘We’ve not yet addressed valuation, though we have brought in a team to do so and will address it in the final rule.’
The valuation debate
Proponents of expensing are not necessarily gloating over the rule change. The next chapter in the expensing story is already beginning to take shape with the valuation issue at its center. Experts are concerned that FASB will have trouble setting useful standards for determining the value of options. They are also concerned that companies will determine and take advantage of loopholes in whatever valuation method FASB endorses.
Case in point: some companies are already changing the inputs they use to value options, most notably the volatility input, measuring a stock’s price swing, which can impact the options’ expense and therefore pretax earnings. The more favorable the assumption on volatility, the more the impact of options expensing on earnings can be reduced. While volatility is down in general, the chance that companies will purposefully make unrealistic assumptions remains.
‘Basically, you can game anything if there are incentives and if there is tolerance of it,’ observes Gary Lutin, a New York-based investment banker and investor advocate. ‘Look at all the creative things people came up with to game revenue.’
‘Years ago, there was no tolerance for doing this sort of thing, and the incentives for management to raise the stock price have obviously increased,’ adds Lutin. ‘So it would be nice if the market developed a consensus view of how options should be valued. I don’t know why anyone thinks Black-Scholes [the most widely used model for valuing options] is reliable. You put in stupid inputs, you get stupid outputs – fantasy numbers.’
For TIAA-Cref’s Clapman, the valuation debate boils down to an issue of transparency: ‘We’ll be looking at valuation closely. Companies that are going forward early on, like Microsoft, are more responsible in terms of gaming, so we’re looking down the road at how the broader universe of companies values options.’
Cutting back
While he shares the concern over potential gaming of the numbers, Clapman believes there is another side to the expensing argument. By requiring expensing of employee stock options on the income statement, FASB is opening the door for companies to embrace other forms of compensation.
‘Only a fixed-price option is not expensed and they have crowded out better forms [of compensation],’ points out Clapman. ‘So whatever FASB decides from an accounting standpoint, another important benefit is that it will be logical for companies to use other forms of compensation because you have removed the disparity of accounting treatment of different types of equity compensation,’ he says.
‘Microsoft figured out that stock options are not the only game in town anymore,’ agrees Alexander Alma, director of research at Sandgrain Securities, an independent research firm. ‘People are suspicious of [options] now. So they don’t want to compensate executives with a discredited instrument,’ he suggests.
Now a number of companies appear to be limiting or moving away from stock options. In addition to Amazon.com and Microsoft, which are shifting to restricted stock grants, Yahoo and Intel say they are going to cap their annual option grants to 2 percent of outstanding shares. All of this coincides with US stock exchanges’ proposed listing requirements for shareholder approval of employee stock option plans.
‘We actually were already scaling back on the number of options,’ notes Iomega’s Zwarenstein. ‘We felt there were some inherent flaws with options, especially that they’re short-term oriented, so we were going toward longer-term cash bonuses and restricted stock for retention and attraction [of employees].’
But despite all the developments that seem to point to a new – and by most accounts, lesser – era for stock options, pockets of resistance remain. In June internet auctioneer eBay, which has seen its stock price rise over 50 percent, announced a massive options grant, giving away an estimated $1 bn worth of options. As per the new rules, the plan was put before shareholders for a vote. They overwhelmingly approved it.
Concern persists
As we’ve reported in the past (see ‘Looking for options’, IR magazine, June 2003), technology companies, which have been the most prodigious issuers of employee stock options, have put up the fiercest resistance to expensing. The impending accounting rule change has softened the rhetoric, but concerns linger.
‘The biggest problem is that you’re trying to have more accuracy, yet you’re asking companies basically to guess when it comes to valuing the cost of employee stock options,’ says Randi Paikoff Feigin, vice president of IR at Juniper Networks. ‘We’ll obviously comply with whatever rule they put out. But we’re not really doing anything differently until FASB says what it is going to require in the new rule.’
Juniper Networks is not alone in its wait-and-see approach. Even non-technology companies remain wary. Fluor Corporation, which announced it would begin expensing following a shareholder vote in support of the move, is not implementing the plan until FASB establishes its new rule. According to Fluor, the investors who sponsored the proposal to expense options are fine with that decision.
‘What we said is that the change to Fluor’s current accounting practices will occur when the ongoing uncertainty is resolved by the adoption of uniform accounting standards,’ says Lila Churney, vice president of IR for Fluor.
She continues, ‘If we were to do so now, we could be placed at a significant competitive disadvantage as most of Fluor’s competitors do not recognize stock option expense in their earnings statements. Our decision gained the support of the proposal’s sponsor, the Carpenters’ Union. They were happy with our commitment to expensing once rules were put forth, and they understood our reasons for not wanting to get out ahead of anyone on that.’
Some companies have, however, sought to take advantage of the one-year transition, and are already expensing stock options in their income statements. Most significantly perhaps are that a few technology companies with large options programs – like Amazon.com – have taken the plunge.
Pro forma bites again
The employee stock options story has managed to spark a revival of another familiar debate: pro forma earnings releases. The reason is simple. For companies that will suffer a drop in Gaap earnings when they start expensing employee stock options, there is a strong temptation to provide pro-forma figures, even when it comes to the impact of restricted shares.
‘To be honest, the whole idea of going to pro-forma numbers is being discouraged. The reality is, in our numbers, we’re talking a nominal amount,’ says Lila Churney, vice president of IR for Fluor. ‘As long as everyone else is consistent, I would be surprised if we’d go that route.’
