Corporate Options

Corporations and the Decision to expense Employee Stock Options

Businesses have always been in competition with each other to provide ever increasing quality, timeliness, and innovativeness of their goods and services. In order for a business to do so, it first needs to attract talented employees. In recent years, one of the more popular strategies for not only luring talent, but keeping them was to offer Stock Options to potential employees. Another use of options that serves companies is in executive compensation packages. For many years critics have argued that salaries and bonuses have been far too excessive and in some cases unwarranted. When a business isn't performing well, should a CEO receive millions while the company's shareholders loose millions as the stock price wanes? To reduce compensation on the books, business had lowered executive pay only to make up for it with generous options offerings. This would also tie in compensation to performance, and hopefully motivate the CEO to see to it that shareholder value is maintained. Stock options have been around since the 1950's , but they have become under scrutiny in the last 20 years, and especially with the more recent dot-com bubble and Enron scandal. For the U.S.'s largest tech companies, in 1970, 3% of outstanding stock was set aside for top executives, in 1995 it was 10% , and in 2003 it was 14%, with total employee equity reaching about 19% .

A recent revision to FASB Statement 123 requires all businesses to eventually expense their options on their income statement using the Fair Value Method. The FASB concluded that: "[An entity in one circumstance (change in control) to settle options for employee compensation in cash. In that case it would meet the criteria for a liability.]" (SFAS 123 (R-4) paragraph 32) This revision has faced opposition from corporations with large amounts of outstanding options. Many tech companies have equity tied up in options that will significantly impact their bottom line. The FASB has been attempting to get the lawmakers behind this initiative since the 90's.

A compensatory stock option plan is designed to provide compensation in addition to their salaries in exchange for the services they provide. A company will grant certain employees the right (the option) to purchase company stock at a set price in the future (exercise price). These rights are not available immediately, the employee needs to fulfill their side of the bargain, or provide services over a specified period of time called the service period. Should the company's stock improve over that period, the employee could serve to make a bundle, as seen from Google's first day of trading that made 1,400 of its employees 'paper' millionaires . But how does a business attribute value to these shares? They could be worth a lot, but then again if the stock price falls, those same shares could be worthless. Since the company is sacrificing an asset, should they account for it the same way they would for a non-monetary asset exchange? The value for at least one of the items exchanged needs to be known. When neither item can be accurately valued, the one with more reliable a value is used. So between an employee's services, and the stock they will receive, they both have amounts attributable to them. The value of the services a company receives by having someone work for the company could be considered measurable by the employee's salary. The value of each share can be measured by it's market value. Since the financial statements are presented in terms of the business, FASB decided a more reliable amount attributable to options would be the value of the assets (shares) sacrificed.

The other major relevant reporting issue is the diluting effect that those options have on earnings per share. The more options that are issued, the less slice of the pie each current investor gets. Advocates say that it is not enough that a company discloses the detail of its options in its notes. The purpose of financial statements is not to be surreptitious, but to increase its usefulness and representational faithfulness. In other words, they are meant to represent the economic and monetary events or transactions as closely as possible. The opposition might note that diluted earnings already have a place on the income statement, the earnings per share calculations.

Finally, two related considerations-the financial and accounting perspective. One of the main reasons for issuing shares is to raise money to either to buy assets, pay liabilities, or fund ongoing operations. The ultimate goal of shareholders is to get a return on their investment that is greater than they could get on the open market, add wealth, and create value. When looked at that way, the company is not really using its stock as it was intended (when shares are used as remuneration)...not that that is necessarily wrong. The point is not to get carried away with giving out options, and to account for the effects properly so that external users and investors can make a better informed judgment. By not expensing options, these companies are in essence giving away shares, and not reaping the benefits of issuing shares which is to raise capital-not loose it. The Accounting powers that be are trying to keep the reporting measures true to this premise of share issuance by regulating the reporting policies of public companies. The Financial community and Accounting community are working with the same goals in mind.

Until now, businesses were able to use the Intrinsic Value Method to come up with the costs to be expensed on the income statement. Basically, the cost to the firm would be calculated by taking the difference between the current market price and the price quoted to the employee (exercise price). The company would then recognize that total cost as an expense over the service period. A few issues that arose with the Intrinsic method were a) The company could just set the exercise price to the market price, negating any difference in value, therefore recognizing no expense. b) If the stock were to appreciate over the future service period, the employee stood to benefit disproportionate to what the company expensed. In addition, the employee only had to pay a capital gains tax, which is lower than income rates. c) The business will show higher income due to the lower expenses, which undermines the feedback and predictive value for external users of the financial statements. On the other hand, there are redeeming features to this method. First is that it uses current, reliable values to calculate costs to be expensed-the market price. Second, since the company is expensing the difference in price that employee will pay to what they would receive by selling