Stock Options

“Earnings are everything, the solid reality of the bottom line that we use in our financial models to determine a company’s value. Yet the are also mere fictions, tales that we’ve agreed to believe as long as they follow certain widely accepted conventions.”

--The Motley Fool, Friday, July 18, 1997 www.fool.com/Rogue/1997/Rogue970718.htm

Current accounting standards require firms to recognize as an expense the value of the compensation they provide in the form of employee stock options. For some types of options, however, firms can choose how to measure that value.

The can use the immediate-exercise value (intrinsic value), which is usually zero, or an estimate of the fair value, which is almost always greater than zero.

According to the CBO, the practice of using the intrinsic vale results in overstatement of reported net income.

March 12, 2003 - Not unexpectedly, the Financial Accounting Standards Board (FASB) decided to open a new project on employee stock options

At their April meeting, the FASB voted to require expensing of stock options.

The FASB move is similar to the stance taken by the IASB, and both groups are receiving significant pressure to back down.

On July 20, 2004, U.S. House of Representatives passed a bill to limit expensing of stock options.

The bill, the Stock Option Accounting Reform Act (H.R. 3574), mandates the expensing of stock options granted to the CEO and the next four most highly compensated officers of a company but exempts the expensing of stock options for all other employees.

However, the Senate has failed to act on the Bill, so it appears that legislative efforts aimed at stopping the requirement to expense options have failed.

The SEC has supported the FASB rules while also allowing companies some flexibility.

Stock Options

An option gives the holder the right, but not the obligation, to buy a share of stock in the future at a predetermined price. The more the stock price rises, the more valuable the option becomes.

Terminology

Option – a contract to buy stock at a specified price

Option Price – the amount you pay for the option (which may be zero, or a nominal sum)

Exercise price, or Strike price – the price at which the option owner can purchase the stock

Expiration date – the final date on which the option owner can purchase the stock

If an owner buys the stock, the owner is said to exercise the option. Normally, options are only exercised when the market price exceeds the strike price.

The date the option is awarded is called the grant date.

To gain final ownership, the employee may have to stay with the company for a period of time, the “vesting period”

Qualifying Stock Option Plans

An incentive stock option allows the employee to purchase stock in the future at a price no less than the fair market value at the grant date.

An employee stock purchase plan, which must be open to all employees, allows the purchase of stock at up to a discount of 15% from the current fair market value.

Non qualifying stock option plans

Any option contract that doesn’t qualify as an incentive stock option or an employee stock purchase plan is considered a non-qualifying plan.

Qualified stock option plans receive preferential tax treatment.

Purpose – to align interests of management, and sometimes employees, with interest of absentee owners – the stockholders

The “average” CEO at one of the nation’s largest companies has been earning about $2 million a year in cash compensation, but an additional $10 - $15 million in options.

Does this create any incentives for management?

One fear is that our reliance on stock option compensation has inordinately caused company management to focus on actions to drive up the price of their stock in the short term in order to provide continuing value for their option programs.

New Rules – Expense Stock Options Pursuant to the SEC’s Final Rule Release

dated April 21, 2005 registrants that are not a small business issuer will be required to prepare financial statements in accordance with FAS 123(R) beginning with the first interim or annual reporting period of the registrants’ first fiscal year beginning on or after June 15, 2005.

“That makes a great deal of sense, rather than forcing them to expense stock options before the beginning of their fiscal years,” says former SEC chair Arthur Levitt.

Current Accounting

Options are not expensed, and do not appear on the income statement.

Does this mean options do not have a value???? (What do you think CEOs would say?”

Can the value be estimated? Black-Scholes, option pricing models…

An area of significant contention is that the current valuation models may be misleading.

In diluted eps, the effect of potential exercise of the options increases the shares of stock outstanding used in the denominator of the eps calculation. The dilution of equity is therefore formally disclosed.

Pro forma net income must be disclosed in the footnotes to the financial statements to show the impact of options on net income if they had been expensed at the grant date.

Business Week, July 14, 2003

If 2002 is any indication, expensing options will likely have a huge impact on profits, slicing 20% off reported earnings

CNET News.Com July 23, 2003

If stock options had to be expensed and disclosed on the income statement…

Siebel Systems would have reported a loss last year of $467 million dollars instead of a profit of $255 million.

Amazon would have seen their net loss increase from $567 million to $963 if they had expensed options

Tax Treatment

For non qualifying stock options, the issuing company may get a significant tax benefit.

Example (Professor Gary Maydew)

Assumptions: Co. has 1 million shares outstanding with a total FMV of

$10 million ($10 per share), with a par value of $2 per share.

CEO is granted 100,000 nonqualified options to acquire stock any time in a five-year period at an option price of $12 per share. At time of grant, the estimated fair market value of the options is $400,000 ($4 per share).

Earnings for years # 1 and 2 without regard to the options are $1.5 million and $2 million respectively.

At the end of year # 1, FMV of stock is $11 per share. At the end of year # 2, when the FMV of the stock has risen to $18 per share, CEO exercises all of the options.

If options are NOT expensed…

Granting of the options No entry on books (except memo entry)

EPS—year # 1 $1,500,000/1,000,000 = $1.50 per share* *The stock options do not figure into the

denominator, because if exercised, the effect would be anti-dilutive, i.e., EPS would increase. (the option price is above the market price)

Exercise of the options

Cash 1,200,000

Common stock 200,000

Paid-in capital 1,000,000 EPS year # 2 $2,000,000/ 1,100,000 = $1.82 per share**

** The options would have been included in the denominator whether or not exercised, because the effect is dilutive (FMV of the stock is above the option price)

If Options ARE Expensed…

Granting of options:

Compensation expense 400,000

Paid-in capital 400,000 EPS year # 1 ($1,500,000-400,000)/1,000,000

= $1.10 per share*

Exercise of OptionsCash 1,200,000

Common stock 200,000

Paid-in capital 1,000,000

EPS—year # 2 $2,000,000/ 1,100,000 = $1.82 per share**

Observations: Intel Letter to Shareholders Bryant asserts that because stock options

are a non-cash expense, and involve an element of subjectivity in their measurement, that the information would be unreliable.

However, companies make all sorts of subjective estimates to arrive at their net earnings (e.g, amortization, bad debt losses, obsolescence of inventory, impairment). The trade-off is between absolute accuracy and relevance, and the accounting profession decided in favor of relevance many years ago.

If, for example, Intel purchased advertising from CBS and paid them in stock options, there would be absolutely no question that the transaction should be recorded (Dr. Advertising Expense, Cr. Paid-in capital). Why is compensation to an employee in stock options any different?

Bryant’s letter boasts that Intel, presumably moderate in its use of stock options, keeps its potential dilution "below an annual average of 2 percent of the total shares outstanding."

However, if one reads the 10K report, the dilutive effect of expensing stock options in 2002 would have reduced EPS from $.46 per share down to $.29 per share, an almost 40 percent reduction.

The Case of Microsoft

A significant portion of the wages Microsoft formerly paid to its employees came in the form of stock options rather than in cash. Compared to the rest of the industry, the amount of cash Microsoft pays its programmers is at best mediocre. It attracts and retains employees via stock options.

At one time, Microsoft essentially guaranteed their employees that they would be millionaires if they worked for the company for 4 years…and this wealth was not based on the salary they earned!

Options give the employees the right to buy a certain number of shares of Microsoft stock at a tiny fraction of the current market price.

Employees can even take an automatic payroll deduction to make the token payment to exercise each stock option as it matures, and thus effectively get shares of Microsoft stock as part of their wages (because the stock has appreciated substantially since it was granted at an exercise price equal to the market price several years prior).

Microsoft's options are "non-qualified," which means the employee is immediately taxed when an option is exercised (i.e., used to actually purchase very cheap stock). The difference between the price the employee pays for the stock and the current market price for the stock they receive is counted as taxable income on the employee's W-2 tax form for the year, as if they'd received it in cash

Because the employee is taxed on this amount as income, the government allows Microsoft to deduct this amount as compensation expense when calculating Microsoft’s taxable income.

In 1999, the additional compensation expense generated a $3.1 billion tax savings for Microsoft…conserving $3.1 billion in cash that Microsoft otherwise would have had to pay to the government.

The purpose behind this tax legislation was to encourage stock options plans because, as we’ll discuss later, many feel that these plans provide important incentives and benefits for corporate growth.

Microsoft has a marginal tax rate of about 35%, so this tax savings represented about $9 billion in compensation expense that Microsoft was allowed to deduct because employees had paid taxes on this amount.

But Microsoft didn’t have to pay ANY of this compensation in cash, and did not record the expense on the income statement.

Its employees got taxed and paid that tax out of their own cash wages, and Microsoft got the money refunded back into its corporate coffers.

Given that Microsoft had about $7.8 billion in net profit, the potential $9 billion in expense would have changed their position from a net profit to a net loss.

But remember…they didn’t pay the compensation in cash, and the dilutive effect of the options was disclosed in their eps calculations.

Not only did Microsoft save significant taxes, they collected $1.3 billion of cash from its employees in that payroll deduction to that employees used to purchase the options.

Microsoft prints stock, pays its employees with the stock, and the stock market provides the cash for Microsoft's employees when they sell the stock or get margin loans against it. Microsoft can print as much stock as it likes in order to pay its employees, and as long as the market keeps wanting to buy shares from those employees, then Microsoft doesn't have to spend too much of its own cash to pay its people. As of July '99, Microsoft had around $60 billion of employee stock options outstanding.

A company that uses a stock option plan similar to the one Microsoft uses does have to deal with the dilutive effect of the shares of stock represented by the option plans. As long as income (productivity) are rising, the dilutive effect may be minimal.

Or…with the cash they generate from the employee stock options via the purchase price and the tax savings, the company can buy back the shares of stock on the open market…reducing the shares of stock outstanding.

It is possible, then, for the company to essentially buy back the shares, potentially giving the cash to the employees that exercised the options and then sold their shares.

But the purchase of treasury stock is NOT an expense on the income statement….

Greenspan

… the very complexity and dynamism of our system requires that we constantly evaluate the tools employed for measuring corporate performance to ensure that they adapt appropriately to the evolving financial and economic environment. In that regard, the increasing use of stock option grants to employees has raised new challenges for our accounting system.

Such options are important to the venture capital industry, and many in high-tech industries have counseled against making any changes to current practices.

They argue that the use of options is an exceptionally valuable compensation mechanism; that recognizing an expense associated with these grants would reduce the use of options, harming high-tech companies; that the effect of options on fully diluted earnings per share is already recognized; and that we cannot measure the costs of options with sufficient accuracy to justify their recognition on financial statements

The seemingly narrow accounting matter of option expensing is, in fact, critically important for the accurate representation of corporate performance

A stock option is a unilateral grant of value from existing shareholders to an employee.

The grant is made to acquire the services of the employee, and presumably has a value equivalent to the cash or other compensation that would have been required to obtain those services--what economists call the opportunity cost of employing those services

That value is obviously a function of when, and under what conditions, the option can be exercised. To assess the cash equivalent of the option, only the market value of the option at the time of the grant matters. Subsequent changes in the value of the option are not relevant to the exchange of labor services for value received, just as future changes in the purchasing power of cash received for services rendered do not affect the firm's compensation costs.

The accurate measurement of input costs is essential for determining whether the corporation earned a profit from its current activities.

To assume that option grants are not an expense is to assume that the real resources that contributed to the creation of the value of the output were free. Surely the existing shareholders who granted options to employees do not consider the potential dilution of their share in the market capitalization of their corporation as having no cost to them.

The particular instrument that is used to transfer value in return for labor services is irrelevant. Its value is not

One may argue that, because option grants are fully disclosed (in the footnotes) and their effect on earnings can, with some effort, be estimated reasonably well, financial markets in their collective wisdom see through the nature of any bookkeeping transactions. Hence, how expenses and profits are reported is of no significance, because nothing in the real world is altered.

Cash flows, for example, are unaffected. The upshot of this reasoning is that stock prices should be unaffected by whether option grants are expensed or not.

Clearly, most high-tech executives believe otherwise.

The measure of diluted earnings per share currently reported by corporations partially reflects the number of shares that employees could obtain with vested but, as yet, unexercised options. Some have maintained that this is all that is required to capture the effects of option grants.

This adjustment corrects only the denominator of the earnings per share ratio. It is the estimation of the numerator that the accounting dispute is all about.

Some have argued against option expensing on the grounds that the Black-Scholes formula, the prevailing means of estimating option expense, is approximate. It is.

But, so is a good deal of all other earnings estimation. Moreover, every corporation already implicitly reports an estimate of option expense on its income statement. That number for most companies, of course, is exactly zero

The continued popularity among employees of option grants as a substitute for cash compensation requires a persistent expected uptrend in a company's stock price.

Should compensation shift more to cash, the trend in reported earnings growth would decline relative to an earnings trend in which options have always been expensed.

Other Issues

Options also received a further boost when Congress passed the $1 million cap legislation in 1993, which placed a cap on tax deductions for nonperformance-based pay to a company's top five executives.

Stock options with an exercise price of fair market value or higher on the grant date qualified as cap-exempt performance-based compensation, while service-vested restricted stock did not.

Employees who receive stock options may not be faced with the same risk of ownership that other equity owners face. When stock options are “out of the money”, a corporation may either reprice the options or cancel the options and issue new options with a lower strike price.

This is not a benefit available to other equity shareholders!

Repricing also raises the question of whether the issuance of options really does align management interests with those of stockholders.

No longer do stock options mean that executives or other employees will only gain if shareholders gain.

One problem is that stock options, as currently structured, often provide only a loose link between compensation and successful management.

A company's share price, and hence the value of related options, is heavily influenced by economy-wide forces--that is, by changes in interest rates, inflation, and myriad other forces wholly unrelated to the success or failure of a particular corporate strategy.

The Opponents

As chief human resources officer at Sun Microsystems, the story I've seen unfold over the past few years is this: Most stock options are not going to executives. In fact, more than 85 percent of Sun's stock options are distributed to rank-and-file workers

So, to me, the story of stock options is primarily one of people working hard, knowing that if the company does well, so will they

Stock options are not a guarantee, but they are a powerful motivator, and that's a large part of their value to companies, their employees, and their stockholders.

Currently, U.S. companies have a choice to either list stock options as an expense or disclose them in financial statement footnotes, which provide more information for investors. Most companies, including Sun, choose the latter, and with good reason: Since there's no accurate way to predict the eventual value of stock options when they're issued -- no way to even know whether they will ever be vested and exercised -- there's no way to state the expense accurately. In fact, it requires guess work -- and creates an unintended but very real potential for manipulation and abuse.

NCEE Data

The National Center for Employee Ownership estimates that employees control 8.3 percent of total U.S. corporate equity, or $663 billion, up from less than 2 percent just a decade ago. Employee stock-option plans account for at least $200 billion of that total, and as many as 7 million employees participate in some 3,000 plans. A decade ago, only 1 million U.S. employees had them.

The high-tech industry's generosity with stock options in the 1990s enabled rank-and-file workers at the 100 largest Internet-based companies to cash in an average of $425,000 each in stock-option profits, according to new research.

``As far as we can determine, never before in the history of the modern corporation has an entire industry handed over so much potential ownership to a broad cross section of employees,'' write Rutgers University professors Joseph R. Blasi and Douglas L. Kruse and Business Week reporter Aaron Bernstein.

Even when tech stocks were melting down in 2000 and 2001, workers below top management pocketed an estimated $25 billion -- or an average of $125,000 -- at companies that ranged from stalwarts such as Cisco Systems and Yahoo to flame-outs such as Excite@Home and Portal Software.

That came on top of an estimated $53 billion -- or $300,000 each -- that workers netted from options during the tech boom the previous six years.

Although those estimates could rankle investors who lost money in those companies, the authors contend that broad-based stock-option plans were one of the best innovations to come out of the tech industry in the 1990s.

As they see it, stock options give ordinary workers a compensation two-fer: the chance to own a long-term stake in their company and take short-term profits

July 15, 2003 – AeA (the nation’s largest high-tech trade association) More than 220 small and mid-sized

companies signed an AeA letter to Congressional leaders today asking for the passage of the Broad-Based Stock Option Plan Transparency Act of 2003.

According to William T. Archey, AeA president and CEO, “The FASB proposal to expense stock options will hurt rank-and-file employees’ ability to participate in the ownership of their own company.

These smaller high-tech companies need stock options for attracting and retaining the most capable workers.

Stock options, given to the vast majority of their employees, provide these companies with a competitive edge for keeping skilled workers.”

The legislation is critical to slowing the rush to judgment and for giving accounting regulators the time they need to evaluate the full range of economic and accounting issues surrounding stock option plans.

Claims of shortcomings:

Requires accounting practices that will obscure the real performance of the company

Provides no flexibility for companies to determine the best way to inform shareholders and investors of accurate financial performance. No single approach works for all companies.

It will force companies to use what is likely a meaningless value for stock options. FASB has acknowledged in the past the difficulty of valuing stock options.

It will actually lead to less information in financial statements that is currently available and give a misleading view of a company. We need more transparency, not less.

A survey conducted by AeA last year found that public high-tech companies on average grant stock options to 84 percent of their employees. The survey also revealed that a full 60 percent of public high-tech public companies provide stock options to all employees.

But Is this Good or Not?

``You can look at the numbers and just by the math you know that a lot of people made a lot of money. But the question is, were these the right people?'' said David Yermack, an associate finance professor at New York University who studies stock options. ``Are these the people who created shareholder value? Or are they the people who came on board at the right firm at the right time?

``The problem with options,'' he said, ``is that sometimes they create more of a short-term mentality.''

Portal Software of Cupertino boasted of creating 350 millionaires, even though it has lost virtually all its value since the stock market peaked in March 2000 and has never posted an annual profit.

A Mercury News examination in December showed that 21 Portal insiders cashed in $704 million in stock, led by founder John Little, who unloaded $127.5 million of shares.

The National Center for Employee Ownership estimates that employees covered by broad-based stock-option plans receive an amount equal to between 12 and 20 percent of their salaries from the "spread" between what they pay for their option stock and what they sell it for.

According to accounting professor Terry Shevlin at the University of Washington, there is little evidence of widespread mistreatment of stock options by the country’s top corporate managers – despite the highly publicized scandals involving former officials at Enron, Global Crossing and Worldcom.

Rather, he says, a study of more than 1,000 corporations shows that for every dollar in stock options given to a company’s top managers, that firm’s earnings go up an average of $2.85 during the next five years.

Others state that investors deserve more accurate and reliable financial statements, and these opponents believe that requiring companies to count stock options as expenses will not give investors the information they need.

Rather, expensing options would be bad accounting policy: it would incorrectly treat options the same as corporate cash expenses and require companies to use valuation methods that are known to be inaccurate and misleading.

An option does not "expense" any asset of a company: it dilutes the ownership of existing investors, but does not take cash out of the company. So the common sense and proper accounting for options should be to show the dilution in the company's equity tables.

From this perspective, the transfer of wealth from other shareholders to employees is not a transaction of the corporation.

Further, many claim that the Black-Scholes formula, the most frequently used valuation method, produces highly misleading results that often significantly overstate the value of employee stock options.

The formula may be particularly problematic for companies with volatile stock prices, such as high-tech, emerging growth companies. For example, one company has found that the "value" of its employee stock options could swing by more than $350 million--roughly 50 percent--by subtly changing just two variables in the Black-Scholes equation: volatility by 15 percent and the "average life of the option" by just one year.

When deciding on Black-Scholes assumptions, companies are supposed to rely on historical experience, modified with a little common sense about what the future is likely to hold.

For example, when estimating option life, companies are supposed to consider not only historical data on option exercises but also factors that may affect future exercises. Capital One Financial (COF ) Corp., for example, reduced its option life expectancy in 2002 to 5 years, from 8.5 years, after granting options with shorter vesting periods. That change cut option costs by $29.3 million.

Jack T. Ciesielski, publisher of the The Analyst's Accounting Observer, found that one out of five companies in the Standard & Poor's 500-stock index reduced option life, stock volatility, or both, in 2002, increasing actual or pro forma earnings in the process

Derek Johnston-Wilson, an assistant accounting professor at Colorado State University, compared accounting assumptions used to value options in 2002 with actual historical trends and found that many companies underestimated both volatility and the risk-free interest rate.

Still others believe that lost in the debate about expensing is that, on the whole, it appears broad-based stock option plans may have been good for investors and employees alike. These opponents of expensing claim that options provide powerful incentives for companies to recruit and retain talented employees, especially during crucial startup periods, that they increase productivity by encouraging employees to act like owners, and that they drive innovation and help spread economic well-being. In short, they believe that stock options are the reason the United States has lead the worldwide technology revolution.

Some have gone so far as to claim that mandatory expensing will put U.S. accounting policy on a collision course with innovation, entrepreneurship, competition, and new business growth. They believe that the next Cisco or Intel won't happen without stock options.

Politics and Stock Options

The last time the FASB tried to require that options be expensed, Congressional pressure, combined with a lack of support from the SEC, caused them to back down. The pro forma impact of expensing was required disclosure in the footnotes, but expensing of options was not required.

Political pressure is still significant. Robert Herz, Chair of the FASB appeared

before Congress: “It would send a clear and unmistakable signal that Congress is willing to intervene in the independent, objective, and open accounting standard-setting process based on factors other than the pursuit of sound and fair financial reporting.”

Democratic Senator Barbara Boxer said a bipartisan group of senators is mapping out a strategy to prevent the Financial Accounting Standards Board (FASB) from possibly forcing companies to treat stock options as expenses, a move that would diminish their use.

When companies grant stock options, they are 'giving people a piece of the dream', Ms Boxer said. 'We can't stand by and let accountants wearing green eye-shades decide who is going to get the American Dream,' the senator added.

Ms Boxer said granting options is 'how our high-tech companies attract the best and the brightest' and if the FASB tries to clamp down on the practice, 'I won't stand by and see it taken away'

House Rules Chairman David Dreier (R-CA) and Anna G. Eschoo (D-CA) are the sponsors of the Broad-Based Stock Option Plan Transparency Act of 2003. This legislation would prohibit FASB from doing anything about the treatment of stock options while the SEC studies the issue for three years….

Drier, according to the Congress Daily AM, claims that expensing stock options “is a public policy issue…not an accounting issue,” and therefore requires lawmakers to weigh-in on the matter. He believes that expensing stock options would be the death knell for employee stock option packages, that would also hobble the ability of startup companies to attract talent, and therefore would stifle innovation. This would “hurt the risk-takers who are creating jobs and wealth in this country.”

John Chambers, CEO of CISCO, claims that a requirement to expense options would force more high-tech jobs overseas…

While the SEC backed down and did not support the FASB in the 1990s when they proposed expensing options, it appears that today the Board has the backing of the SEC.

Former SEC Chairman William Donaldson has stated that Congress should not be in the business of making up accounting rules.

In 2002, Senators Carl Levin (D-Michigan) and John McCain (R-Arizona) introduced legislation that would only allow companies to take a tax deduction for stock options if they also report the expense on their income statement.

According to the WSJ (March 28, 2005) The SEC is expected to assure companies that they will have considerable leeway in measuring the value of employee stock options in financial reports.

SEC guidance is expected to stress that the new FASB standard rejected a one-size-fits all approach to valuing options.

Companies won’t be deemed to be acting unreasonably just because they used different methods to value their employees’ options than other companies in similar situations, or just because they reached different conclusions.

Still, the SEC is expected to stop short of granting companies formal “safe harbor” protection against future litigation over their method of reporting options-related expenses.

The SEC is also expected to respond to criticisms that charge regulators have failed to adequately study the reliability of measurement tools for valuing options.

The issues companies will face in estimating options values “are not unusual and indeed arise in other areas of accounting and finance.”

Companies have “identified suitable methods for estimating future outcomes and obtaining reliable value estimates.”