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The Wall Street Journal, September 3, 2002
Another Option on Options
By Reuven Brenner and Donald L. Luskin
More and more companies are stepping forward to voluntarily include the
expense of stock options in their income statements. This trend is a welcome
step on the road toward reality, away from the present world of illusions in
which options expense is usually treated as though it were zero.
But even as this salutary trend gains momentum, there seems to be a
pervasive sense that it doesn't do enough to provide wary investors with the
information they need about the real impact of options.
Not Ideal
For example, in announcing that General Motors plans to expense options, its
Chief Financial Officer John Devine said, "While we are enthusiastic about
taking steps such as this to restore investor confidence in business, it is
important to point out that current valuation methods available for
expensing stock options are not ideal." And prominently heading The Wall
Street Journal's online list of companies that have volunteered to show
options expense is this warning: "Calculations come from the companies' data
and use the Black-Scholes formula, which links the value of an option to
such variables as the current share price, the exercise price, expected
volatility in share prices and expected dividends. The formula doesn't give
an accurate picture of the cost of options."
The problem is that today's accounting rules leave us with a Hobson's choice
for calculating options expense: zero, or theoretical fair value. Zero is
the frying pan -- options are a form of compensation, and compensation
doesn't cost zero to provide. But fair value is the fire. Fair value is
subjective -- and what's worse, it's just a snap shot made only once at the
time the option is first issued. It's an estimate treated as fact, enshrined
forever in earnings regardless of whether the option turns out in the future
to be worth millions of dollars or to expire worthless.
The fundamental problem with both of the available methods is that they are
looking for options expense in the wrong places. They mistakenly think of
options expense as something that happens when an option is first issued.
But it's not. At the time of issue, options expense really is zero -- that's
the one sense in which the status quo has always been correct. But options
expense occurs when the option is exercised.
It's simple. An executive is issued options when his company's stock is at
$10. When he exercises the options, they'll entitle him to pay $10 for the
stock no matter how high its price in the market. Yes, the company has
conveyed something of real value to the executive -- an option contract that
the executive would have had to pay money for if he'd bought the same thing
from a third party. But the company received something of value, too: the
executive's commitment to work for the company, and probably at lower
up-front wages than would otherwise be the case. It's an even trade -- so
when the option is first issued there is no net cost, not even an intangible
one.
The costs show up when the executive exercises the option sometime in the
future. The executive will make a profit of $40 when he exercises his
options if his company's stock is at $50. That's a fact. It's so objective,
he'll have to pay taxes on that $40.
Since the executive makes $40, it must be that $40 is also the company's
options expense -- there's no such thing as a free lunch. It's a real cost:
the company has to sell stock to the option-holder at $10 when it could have
been issued in a secondary offering at $50. The stock transferred comes from
the company's treasure stocks, which is always available for retirement or
resale. Often, the company purchased the stock to be transferred to the
executives at the $50, and paid either by issuing debt or from retained
earnings. Either way, it costs the company $40 to sell $50 stock for only
$10.
That's a fact, too. It's objective enough that current tax law allows the
company to deduct that $40 from taxable income.
Options expense based on exercise is generally higher over the long run than
options expense based on the fair value approach that companies are now
signing up to adopt. For example, at General Electric, the exercise value
method would have reduced net income by 8.3% on average for fiscal years
1995 to 2001. The fair value method would have reduced it by only 1.3%.
A more profound implication of the exercise approach, though, is that
options expense can't be known until the options are exercised. That means
that options are risky liabilities of unknown future cost -- a short
position in a derivative security, actually. As such, they should be
reflected on the company's balance sheet and marked to market every quarter.
CEOs who wanted to keep options expense off the income statement aren't
going to like putting options liabilities on the balance sheet, since the
latter reveals sharply the higher risk -- exposure of the company -- a cost
not reflected in income statements. The accounting profession complied with
the arrangement, superficially rationalizing the practice as being
consistent with the principle of never putting equity instruments on the
balance sheet.
But keeping options off the balance sheet conceals what is potentially a
vast liability. The language of "equity" vs. "debt" is misleading in a world
where financial instruments have characteristics of both, and where
compensation and capital markets have been integrated in practice (though
not in accounting). At Microsoft, for example, as of the most recent 10-k,
the exercise value of all outstanding options was $23.7 billion dollars.
That's a single liability not shown on the balance sheet that was twice as
big as all the liabilities that are shown.
But the Financial Accounting Standards Board's tradition-bound rules don't
permit investors to see that liability -- the FASB clings to the notion that
executive stock options are "equity instruments," and therefore are not
allowed on the balance sheet.
Putting options on the income statement reveals their expense. Putting them
on the balance sheet reveals their risk. Together, they reveal exactly how
and exactly how much a company is paying for its precious human capital.
Compensation Tools
In brief: Options are valuable -- if imperfect -- compensation tools. So
CEO's should have nothing to fear by bringing all the costs and all the
risks of options into the open. But the worst mistake they could make now
would be to jump from the zero-expense frying pan to the fair-value fire,
simply trading off one erroneous method for another, all in the name of
corporate accountability. Putting options on the balance sheet, and counting
their objective exercise value as their cost, is a solution beyond the
frying pan and beyond the fire, too. It turns the cliché of "people being a
company's most important asset" into sharp, numerical reality.
By bringing the true cost and nature of options into explicit public view,
the debate will focus on the fundamental issues behind the accounting
façade. One such issue is the role of boards and the functioning of markets
for corporate control in awarding these compensations, and significantly
altering the companies' risk profile. Another is whether or not linking
compensations to stock prices, rather than companies' actual performance, is
a good idea to start with.
About the Authors
Mr. Brenner holds the Repap chair at McGill University's School of
Management. His most recent book is
The
Force of Finance (Texere, 2002). Mr. Luskin is chief investment officer
of Trend Macrolytics LLC, and former vice chairman of Barclays Global
Investors. |
