Accounting for Options

Joseph W. Bartlett, Founder of VC

The public reaction to the Enron bankruptcy has rekindled the debate about charging earnings when employees are granted options to purchase their employer's stock. Some years ago, the Financial Accounting Standards Board (as experienced veterans of the campaign are well aware), reached the unsurprising conclusion that options are a form of employee compensation and, therefore, the "value" of the same should be accounted for by charging the employer's earnings contemporaneously with the grant, the idea being that stock options are, economically, essentially another form of currency used to pay the employees; there is no principled reason why one form of currency (say, pesos) should receive a different accounting treatment than another (say, euros).

Unfortunately, the debate on the issue took on political dimensions ... as, indeed, it threatens to do again today. A number of politicians (including some of those jumping today on the bandwagon of the Enron "scandal") argued at the time that accounting for options in the income statement would unjustifiably penalize America's high tech companies, companies which are increasingly forming the backbone of the American economy.

This column does not have anything to add on the political aspects of Enron. Moreover, professionals who are up to speed on the intricacies of accounting for stock options and the related tax issues can stop reading at this juncture. For all others, I think it would be helpful to frame the debate on this matter in non-political terms. (I will also ignore many of the legal and tax intricacies involved in the issue but, I hope, will not over simplify.)

The first point made in the debate has to do with valuation. An option to acquire stock at a set exercise price which is equal to then existing fair market value of a share of stock cannot be valued at a glance, so to speak and, therefore, the idea crept into the accounting canon that no value should be recorded as of the date of the grant and, therefore, no charge to earnings. In recent years, of course, groundbreaking research by Messrs. Black and Scholes has created a methodological platform for valuing warrants and derivative securities as of the date of grant, so the valuation argument has faded (as an intellectual proposition) into the background, by and large.

The second contention of those who would keep the charge out of the income statement is that the grant of a stock option is an exogenous event vis-…-vis the company's profit and loss statement. The idea is that issuing options (and, indeed, issuing stock) has no bearing on the question whether the company is making money (or not) from its operations. The effect of the grant of an option, and the subsequent issuance of the underlying stock, is (to be sure) dilutive to the existing stockholders; [1] but it does not have a bearing on whether the company is producing and selling its products or services in the black or in the red. The proponents of this argument point out that a lender, when looking at the company's income statement, is indifferent to the issue of dilution. To the extent that the issuance of options, in the long run, induces the optionholders to buy the company's stock by exercising the options (if only at a bargain), options could, arguably, enhance the lender's appetite because option exercise strengthens the company's cash position.

There is also an argument to the effect that, if the company does record a charge to earnings on the income statement, the practice will have elements of a 'double count'. Thus, if and as stock options are 'in the money,' either as of the date of the grant in the case of non-qualified stock options, or subsequently because the stock goes up, they are accounted for under the so-called Treasury Method as issued and outstanding shares on a fully diluted basis for purposes of computing earnings per share. And, therefore, the issuance of options does have an immediate (or a near term) effect on how investors perceive the company because it reduces the all-important earnings per share calculation. If you charge the income statement with an expense, thereby reducing the company's net income, and then (in addition) take the option stock into account as part of the earnings per share calculation, it is arguable that the same phenomenon has been recorded twice.

On the other side of the coin, the proponents of instant recognition argue that since (as I have said) options are simply another form of currency, there is a distortion in a company's income statement if the value of the options are not taken into account. Thus, for example, assume two companies which are exactly alike in every other respect except that Company A compensates its work force with stock options and Company B does not. Assuming the cost of labor is the same in both instances, Company A's employees will be willing to take less cash in their paychecks because of the impact of the options. Accordingly, even though every other economic incident of the two companies is precisely the same, Company A will reflect a higher net income (although not necessarily higher earnings per share) than Company B ... and that is a distortion. The distortion between Company A and Company B is amplified if and as Company A's options are non-qualified options . . . as they certainly must be in the case of highly paid executives whose awards break through the $1 million limit on tax-favored stock options. When a non-qualified option is exercised, the spread is ordinary income to the employee and a non-cash tax deduction to the employer, meaning that, despite the identical nature of Company A and Company B referred to above, Company A is further benefited by reducing its federal taxes.

There are remaining macro elements in the debate, which can be characterized as unsettled.

First, the opponents of an income charge argue that, as is currently the case, companies electing (and an election is involved) not to charge the income statement as of the date of option grants (meaning most companies these days) are nonetheless required to set out the requisite data on the company's option practices in the footnotes to the financial statements. The argument then is obvious. Assuming the validity of the Efficient Capital Market Hypothesis and assuming the analytical community is on its toes, who has been fooled? An institutional investor, with the assistance of a competent analyst, should be able (in a relatively short period of time) to reconstitute Company A's financial reporting pro forma . . . to reflect what would have been the result had Company A elected to include options in compensation expense. Whether the market, indeed, does absorb the information and include that information in the respective share prices of Company A and Company B is a matter which has been the subject of controversy, a controversy not yet settled as far as I am aware.

Secondly, it has been vehemently contended that intelligent government policy should encourage, to the maximum extent, the use of stock options as a major element of employee compensation. The idea is that the employees (from the chief executive down to the lowest paid people) will work harder and more effectively if their compensation is tied to the most obvious emblem of a company's success ... rising share prices. This thesis is of long standing vintage, championed vigorously in the Senate by Russell Long when he bought into the 'People's Capitalism' ideas of Louis Kelso and pushed the ESOP amendments to the Internal Revenue Code through the Congress. The validity of this argument has been tested by a variety of academics in recent years, attempting to isolate the influence of employee stock ownership on the fortunes of public companies in the United States. The notion is intuitively appealing; but the conclusions, as I recall, are inconsistent. It has been difficult for the theorists to control for other factors and create pure 'apples to apples' comparisons.

The short of the matter is that, despite the hysteria, there is (as usual) much to be said on both sides of the issue. Too bad the debate is largely on an emotional level.

[1] As our research ally, NYU - Stern School Prof. Alexander Ljungqvist puts it, "A much better way to think about stock options is that the company is creating another class of stockholders. We don't expense the issuance of equity to shareholders, nor should we expense the issuance of stock options to employees. Once one recognizes this, it is clear that stock options are good news for lenders (as you point out); they increase the equity base. Moreover, and more importantly, stock option holders have a very junior claim." Prof. Ljungqvist (who is not responsible for the contents of this Buzz) also points out, "...charging the P&L at the time [and only at the time], of the grant does not make sense, since the value of the option changes whenever the underlying value of the equity changes, so the 'cost' of awarding stock options keeps changing also.'