Wednesday, July 30, 2008

A blast from the past

I haven't had a chance to write anything new on the blog recently. Hopefully that will change soon.

In the mean time, I thought I would post a letter I wrote to the editor of The Wall Street Journal that was published in 2002. I opposed the expensing of employee stock options - obviously FASB disagreed.

My position was based on what I was taught, that accounting is supposed to be a means of communication so that readers of financial statements can better understand the performance of a business. I felt at the time, and I still feel, that the expensing of employee stock options provides more opacity than clarity to readers.

I have also posted the opinion piece that I was responding to.


Letters to the Editor: Stock Options: To Expense or Not to Expense
Wall Street Journal. (Eastern edition). New York, N.Y.: Aug 12, 2002. pg. A.11

In their editorial page commentary, "Options Should Be Reflected in the Bottom Line" (Aug. 1) Zvi Bodie, Robert S. Kaplan and Robert C. Merton argue that options should be expensed and that all arguments to the contrary (of which they identify three) are, at best, poor logic.

I respectfully disagree with their conclusion. Stock options given in employee benefit plans are best represented as dilution. A note including a table setting out the totals of options granted at each price and presenting their related vesting periods would be full disclosure and the best information for investors to interpret.

The argument that expensing options would hurt companies while disclosing them in a note wouldn't, is not, as the professors indicate, contradictory. Many investors look solely at P/E ratios when pricing stocks. Those investors who do not fully analyze financial statements would be confused and misled if options were expensed.

As for expensing options, when an option is granted with a vesting period, that option may never be exercised for two reasons: either the employee may not vest in the option; or the option expires with an exercise price that exceeds the stock price. In those instances, an expense would be recognized for compensation that was not actually expended. This expense would remain in retained earnings and would never be recovered.

Expensing options buries the true effect of the transaction in an inappropriate place on the income statement. Full disclosure in a note together with an EPS table showing the effects of potential dilution is, in my opinion, a better solution.

While I have not taught in a business school nor earned a Nobel prize, I have earned my CPA and my MBA in finance. It's a different perspective from which to consider this issue, but no less valid than those expressed in the piece.

Lawrence D. Loeb


Options Should Be Reflected in The Bottom Line
By Zvi Bodie, Robert S. Kaplan and Robert C. Merton. Wall Street Journal. (Eastern edition). New York, N.Y.: Aug 1, 2002. pg. A.12

There are some issues on which accounting and finance professors disagree, but the expensing of employee stock options is not one of them. Despite the pronouncements of a few renegades in our disciplines, we believe there is near unanimity of opinion among scholars in the fields of accounting and finance that the value of employee stock options should be expensed on a firm's income statement at the time they are granted.

The reasons are clear. Stock options have a market price, so when a company grants options to employees, the company has given up something that has considerable value. This value is the amount the company would have received had these same options been underwritten and sold for cash in a competitive options market. Indeed, Coca-Cola recently led the way when it announced plans to expense employee stock options using competitive bids from investment banks to compute the cost of its options.

Even when a company's options are not traded directly in a market, their approximate price can be inferred from the prices of other securities that are traded in markets. Analysts use mathematical models and formulas to estimate the prices of all types of options. In this respect, options are no different from any other class of financial assets such as stocks, bonds, mortgages, and widely-traded derivative securities.

Sometimes analysts' models provide only a rough estimate of the "true" market value of a nontraded asset. Nevertheless these estimates are used every day to settle transactions involving the payment of billions of dollars, such as in a merger or acquisition.

When a company issues securities whose value can be reasonably determined, accounting principles require that this value be recorded in the company's financial statements. Yet many executives, venture capitalists, politicians, journalists, and even some professional economists have voiced their opposition to proposals that companies reflect the cost of employee stock options on their income statements. We think their arguments make one or more errors in reasoning.

First, some argue that grants of stock options do not involve cash outlays, and therefore no expense should be recorded. This reasoning violates the basic accrual principle of accounting. Not every cash outflow is recorded as an expense in the period in which it occurs, nor does every expense recognized in a period involve a cash outflow. For example, when a company compensates employees by making outright grants of stock or promising future pension benefits, no cash outflows occur. Yet the company would record, as compensation expense, the value of the stock granted or the present value of the pension benefit promised. Stock-option grants should receive comparable treatment.

A second error is to argue that the expensing of stock options would be double counting because the diluting effect of granting the options is recognized by an increase in the number of shares in the denominator of a fully-diluted earnings per share calculation. But by extension this argument would apply to shares of stock granted to employees as well as to stock options. If accepted, companies could issue stock in lieu of salary to employees, ignore the value of the stock issued, and just record the increase in the number of shares outstanding. This erroneous argument would also enable a company to issue stock options to, say, a supplier of materials or energy, and not record the materials or energy consumed as an expense because the effect would show up in the higher number of shares in an earnings-per-share calculation. Curious reasoning.

Third, some argue that employee stock options are worth less than publicly traded options because employees do not gain full ownership of the shares for several years (called the vesting period) and the company may place restrictions on employees' selling their options. But a firm's financial report reflects the perspective of the firm and its shareholders, not the entities with which it contracts. This principle is so fundamental that it is usually taught on the first day of an introductory accounting course. Therefore, the value of the stock option to the company is its cost -- the cash forgone by granting the options to an employee rather than selling them to external investors -- not its value to the person who receives it.

Finally, some opponents of expensing employee stock options make two arguments that actually conflict with each other. First, they claim that it is enough to disclose the information in the footnotes to corporate financial statements as is done now. And second, they claim that to require that options be expensed would hurt companies, particularly high-tech firms that rely heavily on options as a form of compensation. But if deducting the expenses of options that are already disclosed in footnotes would drive a company's stock price down, then we have proof that the disclosure alone was inadequate to capture the underlying economic reality.

The accounting for employee stock options on a firm's income statement should be decided according to economic and accounting principles, not by dubious rationalizations. If the following true-or-false question appeared on an accounting exam, the answer is quite clear: Employee stock options should be expensed on a firm's income statement. True.
Mr. Bodie is a professor of finance at the Boston University School of Management. Messrs. Kaplan and Merton are professors of accounting and finance, respectively, at Harvard Business School. Mr. Merton won the Nobel Prize in 1997 for his work on option pricing.

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