Description
As part of its due process, the Financial Accounting Standards Board (FASB) gathers feedback on its
proposed standards. In many cases the organizations or persons responding provide useful information
because they provide a viewpoint the FASB has not fully considered or else provide technical information
about a particular industry or practice the FASB has failed to consider.
In this assignment, you will learn some basic background about what an employee stock option is, how it
works. With that background information you are going to evaluate the arguments raised by the CFO of
Micron Technology in his letter providing feedback to the FASB on the proposed standard on share-based
payments that later was finalized as SFAS 123R, Share-Based Payments. SFAS 123R, later codified as
ASC 718, requires companies to recognize expenses using the fair value of the stock options granted to
executives and employees.
Required:
Read the first three pages of the of the article “How do employee stock options work,” by Samuel Deane
of Morningstar. Then read the comment letter from Micorn’s CFO. Write a memo using the format in
the Memo Guidelines to address the following three questions:
1. Briefly describe what an employee stock option is and how it works? Why might an employer want
to use employee stock options, vs other forms of compensation? Why might employees want
employee stock options, vs other forms of compensation?
2. The first two logical arguments raised by Micron by the main points of their memo are:
a. Employee stock options granted at market price do not constitute an “expense” under present
accounting definitions, do not represent an economic cost to the issuer and should not be
recognized as a compensation expense of the issuing company.
b. The measurement methodologies and tools recommended by FASB rely significantly on
management judgments and estimates and will lead to a lack of consistency and
comparability among reported results.
Do the principles in the FASB’s conceptual framework lead you to agree or disagree with each of
these two arguments raised by Micron? Discuss each argument separately, identify relevant aspects
of the conceptual framework that you believe are relevant to the arguments being made by Micron.
Be sure to explain why the conceptual framework supports or contradicts the arguments being made
by Micron.
3. Based on your general understanding of the FASB’s conceptual framework and the debate over
expensing stock-based compensation, would you support or oppose to FASB’s requirement of
recognizing stock-based compensation expense measured using fair value? Explain your answer and
provide justification for your views. Be sure to draw from the various aspects of the conceptual
framework.
There is not necessarily right or wrong answer to each question. Express your opinion and back them up
with facts and reasoning, particularly reasoning based on the conceptual framework. Do some research
online. You can use all available literature as reference, including those listed below. Be sure to cite any
sources that you use to develop insights or provide direct quotes from (e.g., sections of the codification,
articles).
Your memo should be no more than four pages. You should use 12-point Times New Roman font, oneinch margin on all sides, double spacing in the main text and single spacing in the header.
Unformatted Attachment Preview
American Economic Association
Accounting for Employee Stock Options
Author(s): Wayne Guay, S. P. Kothari and Richard Sloan
Source: The American Economic Review, Vol. 93, No. 2, Papers and Proceedings of the
OneHundred Fifteenth Annual Meeting of the American Economic Association, Washington,DC,
January 3-5, 2003 (May, 2003), pp. 405-409
Published by: American Economic Association
Stable URL: https://www.jstor.org/stable/3132262
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Accounting for Employee Stock Options By WAYNE GUAY, S. P. KOTHARI, AND RICHARD
SLOAN* Employee stock options (ESO’s) are a ubiq- uitous form of compensation in corporate
America. By the late 1990’s, ESO’s outstanding at large corporations averaged 7 percent of total
outstanding shares, with top executives holding approximately one-third of total ESO’s (John Core
and Guay, 2001). Empirical evidence sug- gests that firms use ESO’s to align employees’ and
shareholders’ interests, attract and retain employees, and compensate employees for their labor
while simultaneously raising capital from employees (Core and Guay, 1999, 2001; Kevin J. Murphy,
1999). There is currently an intense debate nation- ally and internationally among standard-setters,
politicians, investors, corporate executives, and academics about whether to require corpora- tions
to deduct the estimated value of ESO grants as a business expense in reported income. Existing
accounting standards require firms to expense most forms of pay, such as salaries, cash bonuses,
and the value of stock grants, but allow firms to choose whether to expense the value of ESO
grants. Until very recently, nearly all firms chose not to expense ESO’s. However, firms that do not
expense ESO’s must publicly disclose in the financial statement footnotes what reported income
would have been if the ESO’s were expensed. In a recent sample of large growth firms, Christine
Botosan and Marlene Plumlee (2001) find that mandatory expensing of ESO’s would have resulted
in a 14-percent median reduction in firms’ earnings per share. Firms are also required to disclose
details of top-executive ESO compensation in the annual proxy statement. Underlying the ESO
debate is the concern that the choice among alternative financial- accounting treatments have real
economic con- sequences. A large literature beginning with * Guay: Wharton School, University of
Pennsylvania, Philadelphia, PA 19104; Kothari: Sloan School of Manage- ment, Massachusetts
Institute of Technology, Cambridge, MA 02142; Sloan: University of Michigan Business School, Ann
Arbor, MI 48109-1234. We acknowledge helpful com- ments of John Core, Rich Frankel, and Joe
Weber. 405 Ross Watts and Jerold Zimmerman (1978) pro- vides evidence that accounting choice
can im- pose economic costs on firms when contracts (e.g., debt and executive compensation contracts) or influential external parties (e.g., tax authorities) rely on reported accounting num- bers (see
Thomas Fields et al. [2001] for a survey of this literature). Accounting choice can also have
economic consequences if investors fixate on particular numbers, such as reported earnings,
resulting in security mispricing and misallocation of capital. Proponents of mandatory expensing
argue that ESO’s reflect a cost of acquiring employee labor, and that expensing ESO’s conveys this
information to outsiders consistently with other labor costs. Some argue that the absence of ESO
expense results in stock mispricings, because investors fixate on reported earnings and fail to
understand or utilize supplemental footnote dis- closures about the true economic cost of ESO
grants. Others argue that, when investors and boards of directors fixate on accounting earn- ings,
the absence of ESO expense exacerbates ineffective corporate governance and allows
management to use ESO’s to extract excessive compensation. Proponents of this view argue that
expensing ESO’s will reign in management compensation by putting it under a brighter light.
Opponents of expensing ESO’s argue that deducting the cost of ESO’s from earnings con- veys an
impression of weaker financial results to investors and, under the assumption that in- vestors fixate
on reported earnings, could raise the firms’ cost of financing and stifle corporate investment and
innovation. There is also a con- cern that external parties, such as taxing author- ities, might use
changes in financial-accounting treatment as a cue to alter regulatory and tax policy. I. Accounting
Issues The ESO transaction involves the exchange of labor inputs for a contingent equity claim on
AEA PAPERS AND PROCEEDINGS the firm, and it raises several complex account- ing issues. We
consider three such issues below. A. ESO Issuance Combines Operating and Financing Activities
Granting ESO’s is economically equivalent to two separate transactions. In the first trans- action, the
firm sells warrants to the employee for cash. This is a pure financing transaction, resulting in the
generation of cash and an in- crease in the firm’s equity capital. In the second transaction, the firm
pays the cash to the em- ployee as compensation for services rendered. This is a pure operating
transaction, resulting in the subsequent use of resources and a corre- sponding charge to earnings.
Thus, consistent with the existing accounting for stock grants to employees, the proper accounting
treatment for an ESO grant is an entry to increase contributed equity capital and an entry to deduct
the value of ESO’s from reported earnings. To see this point, consider two economically equivalent
firms: firm A issues common-stock warrants to investors for cash and then uses cash to pay for all
production inputs; firm B uses ESO’s to pay for all production inputs. Firm A computes earnings as
revenue received from the sale of the inputs less the purchase price of the inputs. Assuming no
expense for ESO’s, firm B’s earnings equal revenues. Thus, earnings are very different across the
two firms, yet both firms raise the same amount of capital and gen- erate the same economic
earnings. Many prominent business leaders, such as Harvey Golub (former CEO, American Express) and Andrew Grove (CEO, Intel), argue passionately against expensing ESO’ s. Their argument is that the economic impact of ESO’s manifests itself through shareholder dilution, and that
the denominator in the computation of earnings per share (EPS) already adequately captures the
“dilution cost” of ESO’s. As a result, expensing ESO’s essentially double- counts the cost of ESO’s.
As background, for a firm with common stock and ESO’s outstand- ing, the denominator in the
computation of EPS is the sum of (i) the average number of out- standing common shares and (ii)
an adjustment for outstanding ESO’s based on a formula that converts the number of outstanding
ESO’s into an “equivalent” number of common shares. However, the above argument is flawed. It
makes the mistake of confusing the financing implications of raising equity capital with the operating
costs of paying for operating re- sources. To clarify this point, consider the fol- lowing two firms. Firm
A initially holds $200 in assets funded by 20 shares of common stock issued at $10 per share. Firm
A sells the assets for $220, recognizes $220 of revenue and $200 of expense. Earnings are $20,
and EPS is $1 ($20/20 shares), reflecting a 10-percent return on equity capital. Firm B holds $100 in
assets funded by 10 shares of common stock issued at $10 per share and also grants $100 of stock
to a new employee in return for labor worth $100. Firm B then sells the assets and labor for $220. If
the cost of the new labor is not expensed, firm B recognizes $220 of revenues and $100 of expense.
Earnings are $120, and EPS is $6 ($120/20 shares), reflecting a 60-percent return on equity capital.
Although both firms generate a 10-percent eco- nomic return on capital, firm B’s EPS reflects a
misleading accounting return of 60 percent on capital. Note that, because the denominator of firm
B’s EPS includes an adjustment for the 10 shares of stock issued to acquire labor, the prob- lem with
firm B’s EPS stems solely from the failure to deduct labor expense from reported earnings in the
numerator. This example illus- trates the need for an EPS measure where (i) the numerator of EPS
includes a deduction for ESO grants to reflect the cost of the labor resources received by the firm
upon granting the option, and (ii) the denominator includes an adjust- ment for outstanding shares
and ESO’s to reflect the fact that existing shareholders and option hold- ers have an economic claim
on the firm’s earnings performance.1 Although the above ex- ample assumes stock shares (not
ESO’s) are granted to acquire labor, the economic intuition is identical when ESO’s are granted to
acquire labor (see Dieter Hess and Erik Lueders, 2001; Core et al., 2002). 1 Core et al. (2002)
document that, although an ESO adjustment to the denominator of EPS is indeed necessary, the
current accounting rules require an adjustment that understates the economic dilution of outstanding
ESO’s by about 50 percent, on average. 406 MAY 2003
LESSONS FROM ENRON B. ESO Grants Are a Barter Transaction Granting ESO’s is a barter
transaction in- volving the exchange of labor services for a contingent equity claim. As with all barter
transactions, determination of the fair value of the exchange is an accounting issue. Although optionpricing techniques (e.g., Black-Scholes) are well developed, ESO’s have features, such as vesting
provisions, nontransferability, and accelerated maturity when the holder terminates employment, that
deviate from the assumptions underlying standard option-pricing models for publicly traded options.
As a result, managers’ exercise policies likely deviate from the as- sumptions underlying the BlackScholes frame- work (e.g., Steven Huddart, 1994; Charles Cuny and Philippe Jorion, 1995).
Reasonable solu- tions to this problem have been proposed in which ESO’s are valued using the
expected time until exercise (e.g., Thomas Hemmer et al., 1994). Accounting standard-setters are
often reluc- tant to recognize numbers in the financial state- ments that cannot be measured reliably
(e.g., research and development expenditures are not recognized as assets because it is argued
that the future benefits of these expenditures cannot be reliably estimated). Some argue that ESO’s
should not be expensed for this reason. Further, empirical evidence suggests that some firms use
discretion in the assumptions underlying ESO valuation to manipulate ESO expense (David Aboody
et al., 2002). However, we believe that ESO grant valuation is no more complicated than the
estimation of many other common cor- porate expenses (e.g., the annual expense recog- nized for
pensions and postretirement benefits is based on estimates of the present value of future retirement
benefits earned by current employees during the year). A related argument is that, because employees are risk-averse and are not allowed to con- struct the type of risk free hedges that form the basis
for option pricing models, traditional option- pricing models may overvalue ESO grants from the
employee’s perspective (e.g., Brian Hall and Murphy, 2002). Some firms use these argu- ments to
justify either a lower option expense or to bolster the case against the reliable measure- ment of
ESO value. However, regardless of employees’ valuation of ESO’s, it is the cost of the ESO grant to
the firm’s existing owners rather than the employees’ valuation that mat- ters when determining the
appropriate amount to expense. To illustrate, companies sometimes reward employees with fringe
benefits for in- centive or reward purposes, such as first-class air tickets or country-club
memberships. The fact that some employees value these perqui- sites at less than company cost
does not mean that the company should expense these benefits at less than cost. C. ESO’s as a
Contingent Financial Obligation Through Time A third issue arising in expensing ESO’s is the
treatment of changes in the fair value of the contingent equity claim between the grant and exercise
dates. The amount of value the option holder ultimately receives depends on the exer- cise value
(i.e., share price) at the exercise date. Thus, because option-holders bear risk associ- ated with
changes in equity value over time, ESO’s provide existing shareholders with a form of insurance
against future firm performance. An interesting accounting issue is whether the ex post realization of
the risk borne by the option holders should be reflected in firm earn- ings. That is, should changes in
ESO value between the grant and exercise dates be in- cluded as a component of earnings to
reflect the fact that option-holders receive a portion of any change in the net asset value of the firm?
Such an approach is consistent with an accounting objective where earnings appropriately reflect
any change in the common stockholders’ net assets (i.e., assets less liabilities). A problem with this
approach is that the change in ESO portfolio value reflects changes in the firm’s stock price, and
stock price reflects the capitalized change in the present value of expected firm earnings. Because
accounting earnings generally do not reflect changes in the present value of most assets, markingto-market some components of equity, but not assets, may result in an earnings stream that hinders
market participants in assessing the amounts and risk of firms’ future cash flows.2 2 For example,
consider a technology firm with substan- tial outstanding ESO’s whose stock price rises substantially
VOL. 93 NO. 2 407
AEA PAPERS AND PROCEEDINGS II. Economic Consequences of Expensing ESO’s Accounting
for ESO’s is one of the most controversial accounting issues in recent his- tory. Corporate America
and the major account- ing firms lobbied aggressively against the mandated expensing of stock
options during the 1990’s. Their efforts forced the Financial Ac- counting Standards Board (FASB) to
back down and recommend, but not require, the ex- pensing of ESO’s. The FASB summarizes the
most commonly voiced concern with the man- datory expensing of ESO’s as follows (from “FASB
Preliminary Summary of Responses to Exposure Draft,” issued 30 June 1993): Respondents who
objected to the pro- posed accounting on the basis of public policy concerns asserted that the
recogni- tion of compensation costs for fixed stock options will result in lower stock prices and higher
costs of capital and will there- fore cause many companies to eliminate or significantly curtail their
stock-price based compensation programs. Firms publicly disclose details of ESO plans in their
financial statements, including the esti- mated cost of option grants and the total number of ESO’s
outstanding. Details about the level and composition of top executives’ compensa- tion, including the
estimated value of the ESO grants, are disclosed publicly in the annual proxy statement. Thus, the
concern described above relies on a form of market inefficiency where marginal investors fixate on
reported earnings and ignore information about business expenses not explicitly recognized in
contem- poraneous earnings. Accumulated empirical re- search over the past four decades
contradicts this extreme form of market inefficiency (for evidence that investors do not ignore ESO
dis- closures see Aboody [1996] and Timothy Bell et al. [2002]). Even if markets were character- due
to good news about future sales from a newly patented product. If the firm expenses the increase in
ESO value that results from the increased stock price, the firm will experi- ence a sharp decline in
reported earnings in a period where good news occurs. The potential informational problem here
stems from the fact that reported accounting earnings in general do not capture large portions of the
information reflected in current stock returns. ized by such inefficiency, however, it would seem to
strengthen the case for recognizing these very real costs in earnings. Given these arguments, why
are many firms and executives so staunchly opposed to the ex- pensing of options? Equally
importantly, what would be the benefit of changing accounting to require coporations to expense
ESO’s? One hypothesis for executives’ opposition to expensing ESO’s, is that it would influence
con- tracting arrangements by making ESO compen- sation to top executives more visible. This, in
turn, would make it more difficult for top exec- utives in firms characterized by poor corporate
governance to justify awarding themselves ex- cessively lucrative pay packages. Contracting and
transactions costs render corporate gover- nance an imperfect process, and unlike stock prices
(which evidence suggests are influenced primarily by marginal investors), the effective- ness of
corporate governance depends on the actions of all voting shareholders. Individual shareholders
often do not have strong incentives to expend effort on governance activities, and without a
transparent and potentially contract- ible number associated with ESO grants, some top executives
can use ESO’s to transfer wealth from shareholders. Supporting empirical evi- dence finds firms that
most actively lobbied against the expensing of ESO’s are character- ized by having top executives
who receive a greater proportion of their compensation from options, receive higher total
compensation, and use ESO’s more aggressively for themselves versus other employees (Patricia
Dechow et al., 1996). This hypothesis generates an empirical prediction that ESO awards,
especially to top executives, will decline following the manda- tory expensing of ESO’s, particularly
in firms with ineffective corporate governance. Re- cently, many firms have voluntarily expensed the
cost of ESO grants. The hypothesis also predicts that the governance of expensing firms is more
effective than that of the non-expensers.3 3 We note, however, that compensation contracts will only
be written efficiently if boards and investors fully understand both the cost of ESO’s and the
incentive effects of options, stock, cash, and other forms of compensation. Reaching agreement
about the appropriate ESO expense and conveying this information to boards and investors is likely
to be much easier than the difficult tasks of ensuring 408 MAY 2003
LESSONS FROM ENRON A final possibility to explain firms’ opposi- tion is that expensing ESO’s
imposes real eco- nomic costs on firms related to contracting or influential external parties. For
example, lower publicly reported profits due to ESO expense might result in the loss of customer
confidence or more binding debt covenants. Alternatively, young growth firms that rely heavily on
ESO’s may fear that the FASB’s endorsement of ESO expense will prompt the IRS to tax ESO
grants to employees as regular compensation, instead of deferring employee tax until exercise. III.
Conclusion Corporate and political pressures should not determine ESO accounting rules. ESO’s
are a key component of top executive compensation that serve useful contracting functions. However, the goal of accounting is not to distort financial performance to subsidize particular business
activities. Accounting should reflect the true costs of doing business, and labor ac- quired through
ESO grants is a real economic cost that firms should deduct from earnings as an expense. Armed
with clear information on operating costs, investors, creditors, boards of directors, and regulators
should be left to deter- mine business practice. REFERENCES Aboody, David. “Market Valuation of
Employee Stock Options.” Journal of Accounting and Economics, August-December 1996, 22(1- 3),
pp. 357-91. Aboody, David; Barth, Mary and Kasznik, Ron. “Do Firms Manage Stock-Based
Compensa- tion Expense Disclosed Under SFAS 123?” Working paper, Stanford University, 2002.
Bell, Timothy; Landsman, Wayne; Miller, Bruce and Yeh, Shu. ‘The Valuation Implications of
Employee Stock-Option Accounting for Profitable Computer Software Firms.” Account- ing Review,
October 2002, 77(4), pp. 971-96. Botosan, Christine and Plumlee, Marlene. “Stock Option Expense:
The Sword of Damocles that boards and investors understand the incentive effects of various types
of compensation contracts, and understand which contracts are most efficient in certain settings.
Revealed.” Accounting Horizons, December 2001, 15(4), pp. 311-27. Core, John and Guay, Wayne.
“The Use of Eq- uity Grants to Manage Optimal Equity Incen- tive Levels.” Journal of Accounting
and Economics, December 1999, 28(2), pp. 151- 84. . “Stock Option Plans for Non-executive
Employees.” Journal of Financial Econom- ics, August 2001, 61(2), pp. 253-87. Core, John; Guay,
Wayne and Kothari, S. “The Economic Dilution of Employee Stock Op- tions: Diluted EPS for
Valuation and Finan- cial Reporting.” Accounting Review, July 2002, 77(3), pp. 627-52. Cuny,
Charles and Jorion, Philippe. “Valuing Executive Stock Options with a Departure Decision.” Journal
of Accounting and Eco- nomics, September 1995, 20(2), pp. 193-205. Dechow, Patricia; Hutton,
Amy and Sloan, Rich- ard. “Economic Consequences of Accounting for Stock-Based
Compensation.” Journal of Accounting Research, Supplement 1996, 34, pp. 1-20. Fields, Thomas;
Lys, Thomas and Vincent, Linda. “Empirical Research on Accounting Choice.” Journal of Accounting
and Economics, Sep- tember 2001, 31(1-3), pp. 255-307. Hall, Brian and Murphy, Kevin. “Stock
Options for Undiversified Executives.” Journal of Ac- counting and Economics, February 2002,
33(1), pp. 3-42. Hemmer, Thomas; Matsunaga, Steven and Shev- lin, Terry. “Estimating the ‘Fair
Value’ of Employee Stock Options with Expected Early Exercise.” Accounting Horizons, De- cember
1994, 8(4), pp. 23-42. Hess, Dieter and Lueders, Erik. “Accounting for Stock-Based Compensation:
An Ex- tended Clean Surplus Relation.” Working paper, University of Konstanz, Germany, 2001.
Huddart, Steven. “Employee Stock Options.” Journal of Accounting and Economics, Sep- tember
1994, 18(2), pp. 207-31. Murphy, Kevin J. “Executive Compensation,” in Orley Ashenfelter and
David Card, eds., Handbook of labor economics, Vol. 3. Am- sterdam: North-Holland, 1999, pp.
2485-2563. Watts, Ross and Zimmerman, Jerold. “Towards a Positive Theory of the Determination
of Ac- counting Standards.” Accounting Review, January 1978, 53(1), pp. 112-34. VOL. 93 NO. 2
409
ACCOUNTING
For the Last Time: Stock Options Are an Expense
by Zvi Bodie , Robert S. Kaplan and Robert C. Merton
From the March 2003 Issue
T he reporting controversy time has of come has executive been to end going stock the on options debate far too on dates long. accounting
back In fact, to 1972, for the stock rule when governing options; the the the Accounting Principles Board, the predecessor to the Financial
Accounting Standards Board (FASB), issued APB 25. The rule specified that the cost of options at the grant date should be measured by their
intrinsic value—the difference between the current fair market value of the stock and the exercise price of the option. Under this method, no
cost was assigned to options when their exercise price was set at the current market price.
The rationale for the rule was fairly simple: Because no cash changes hands when the grant is made, issuing a stock option is not an
economically significant transaction. That’s what many thought at the time. What’s more, little theory or practice was available in 1972 to guide
companies in determining the value of such untraded financial instruments.
APB 25 was obsolete within a year. The publication in 1973 of the Black-Scholes formula triggered a huge boom in markets for publicly traded
options, a movement reinforced by the opening, also in 1973, of the Chicago Board Options Exchange. It was surely no coincidence that the
growth of the traded options markets was mirrored by an increasing use of share option grants in executive and employee compensation. The
National Center for Employee Ownership estimates that nearly 10 million employees received stock options in 2000; fewer than 1 million did in
1990. It soon became clear in both theory and practice that options of any kind were worth far more than the intrinsic value defined by APB 25.
FASB initiated a review of stock option accounting in 1984 and, after more than a decade of heated controversy, finally issued SFAS 123 in
October 1995. It recommended—but did not require—companies to report the cost of options granted and to determine their fair market value
using option-pricing models. The new standard was a compromise, reflecting intense lobbying by businesspeople and politicians against
mandatory reporting. They argued that executive stock options were one of the defining components in America’s extraordinary economic
renaissance, so any attempt to change the accounting rules for them was an attack on America’s hugely successful model for creating new
businesses. Inevitably, most companies chose to ignore the recommendation that they opposed so vehemently and continued to record only
the intrinsic value at grant date, typically zero, of their stock option grants.
Subsequently, the extraordinary boom in share prices made critics of option expensing look like spoilsports. But since the crash, the debate has
returned with a vengeance. The spate of corporate accounting scandals in particular has revealed just how unreal a picture of their economic
performance many companies have been painting in their financial statements. Increasingly, investors and regulators have come to recognize
that option-based compensation is a major distorting factor. Had AOL Time Warner in 2001, for example, reported employee stock option
expenses as recommended by SFAS 123, it would have shown an operating loss of about $1.7 billion rather than the $700 million in operating
income it actually reported.
We believe that the case for expensing options is overwhelming, and in the following pages we examine and dismiss the principal claims put
forward by those who continue to oppose it. We demonstrate that, contrary to these experts’ arguments, stock option grants have real cashflow implications that need to be reported, that the way to quantify those implications is available, that footnote disclosure is not an acceptable
substitute for reporting the transaction in the income statement and balance sheet, and that full recognition of option costs need not
emasculate the incentives of entrepreneurial ventures. We then discuss just how firms might go about reporting the cost of options on their
income statements and balance sheets.
Fallacy 1: Stock Options Do Not Represent a Real Cost
It is a basic principle of accounting that financial statements should record economically significant transactions. No one doubts that traded
options meet that criterion; billions of dollars’ worth are bought and sold every day, either in the over-the-counter market or on exchanges. For
many people, though, company stock option grants are a different story. These transactions are not economically significant, the argument
goes, because no cash changes hands. As former American Express CEO Harvey Golub put it in an August 8, 2002, Wall Street Journal article,
stock option grants “are never a cost to the company and, therefore,
should never be recorded as a cost on the income statement.”
That position defies economic logic, not to mention common sense, in several respects. For a start, transfers of value do not have to involve
transfers of cash. While a transaction involving a cash receipt or payment is sufficient to generate a recordable transaction, it is not necessary.
Events such as exchanging stock for assets, signing a lease, providing future pension or vacation benefits for current period employment, or
acquiring materials on credit all trigger accounting transactions because they involve transfers of value, even though no cash changes hands at
the time the transaction occurs.
Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost, which needs to be accounted
for. If a company were to grant stock, rather than options, to employees, everyone would agree that the company’s cost for this transaction
would be the cash it otherwise would have received if it had sold the shares at the current market price to investors. It is exactly the same with
stock options. When a company grants options to employees, it forgoes the opportunity to receive cash from underwriters who could take
these same options and sell them in a competitive options market to investors. Warren Buffett made this point graphically in an April 9, 2002,
Washington Post column when he stated: “Berkshire [Hathaway] will be happy to receive options in lieu of cash for many of the goods and
services that we sell corporate America.” Granting options to employees rather than selling them to suppliers or investors via underwriters
involves an actual loss of cash to the firm.
It can, of course, be more reasonably argued that the cash forgone by issuing options to employees, rather than selling them to investors, is
offset by the cash the company conserves by paying its employees less cash. As two widely respected economists, Burton G. Malkiel and William
J. Baumol, noted in an April 4, 2002, Wall Street Journal article: “A new, entrepreneurial firm may not be able to provide the cash compensation
needed to attract outstanding workers. Instead, it can offer
stock options.” But Malkiel and Baumol, unfortunately, do not follow their observation to its logical conclusion. For if the cost of stock options is
not universally incorporated into the measurement of net income, companies that grant options will underreport compensation costs, and it
won’t be possible to compare their profitability, productivity, and return-on-capital measures with those of economically equivalent companies
that have merely structured their compensation system in a different way. The following hypothetical illustration shows how that can happen.
Imagine two companies, KapCorp and MerBod, competing in exactly the same line of business. The two differ only in the structure of their
employee compensation packages. KapCorp pays its workers $400,000 in total compensation in the form of cash during the year. At the
beginning of the year, it also issues, through an underwriting, $100,000 worth of options in the capital market, which cannot be exercised for
one year, and it requires its employees to use 25% of their compensation to buy the newly issued options. The net cash outflow to KapCorp is
$300,000 ($400,000 in compensation expense less $100,000 from the sale of the options).
MerBod’s approach is only slightly different. It pays its workers $300,000 in cash and issues them directly $100,000 worth of options at the start
of the year (with the same one-year exercise restriction). Economically, the two positions are identical. Each company has paid a total of
$400,000 in compensation, each has issued $100,000 worth of options, and for each the net cash outflow totals $300,000 after the cash received
from issuing the options is subtracted from the cash spent on compensation. Employees at both companies are holding the same $100,000 of
options during the year, producing the same motivation, incentive, and retention effects.
How legitimate is an accounting standard that allows two
economically identical transactions to produce radically different
numbers?
In preparing its year-end statements, KapCorp will book compensation expense of $400,000 and will show $100,000 in options on its balance
sheet in a shareholder equity account. If the cost of stock options issued to employees is not recognized as an expense, however, MerBod will
book a compensation expense of only $300,000 and not show any options issued on its balance sheet. Assuming otherwise identical revenues
and costs, it will look as though MerBod’s earnings were $100,000 higher than KapCorp’s. MerBod will also seem to have a lower equity base
than KapCorp, even though the increase in the number of shares outstanding will eventually be the same for both companies if all the options
are exercised. As a result of the lower compensatio
