Stock options are a tool that was increasingly utilized in the '80's and '90's to align management and executives' interests with those of the firm. Originating in start-ups, options spread to the Fortune 500 where it is estimated they now account for approximately 60% of executive compensation. Options have sometimes been controversial, such as times when executives have been granted options valued at hundreds of millions of dollars. Critics claim that overly generous stock options result in excessive compensation for executives, and may also give them an incentive to manipulate their company's finances to inflate stock prices.... However, this OPED does not address this aspect of stock options, but rather their accounting treatment and how they are treated on companies' financial statements and tax returns.
Although stock options are a form of compensation they don't count as an expense on a company's books. However when options are exercised the companies treat them as a cost and deduct the difference between the strike price and what they could have received by selling the stock on the open market. This has given many companies significant tax advantages e.g. in 2000 Microsoft saved over $2 billion and Cisco $1.4 billion in taxes by deducting stock option costs. Critics claim that the net effect of options is to exaggerate profits while reducing taxes. In the past efforts have been made to change the accounting treatment of stock options. In 1994 the Financial Accounting Standards Board proposed changing the rules so that stock options would have treated as expenses. A coalition of business interests lobbied the Senate and pressured the FASB, which retreated, finally only requiring companies to include information on stock options in the footnotes of their financial reports (FAS 123).
Following the Enron debacle the subject of the treatment of stock options has again come to the fore. In the Senate a bill to require that companies subtract the cost of stock options if they avail themselves of the tax advantages has been introduced by Senators Carl Levin (D-MI) and John McCain (R-AZ). A similar measure has been introduced in the House. People and institutions that have come out in favor of companies deducting the cost of stock options on their balance sheets include Federal Reserve Board Chairman Alan Greenspan, formed FED Chairman Paul Volcker, former SEC head Arthur Levitt, mega-investor Warren Buffet, Standard & Poors, the Council of Institutional Investors, and many others. Arrayed against them are a number of business organizations, Silicon Valley companies, venture capitalists, and many other groups. This is a high stakes battle. The Federal Reserve has estimated that if stock options had been expensed the Fortune 500's profit margins from 1995 to 2000 would have dropped from 12% to 9.4%. A Bear Stearns study estimated that if options were an expense the earnings per share of the S&P 500 companies would have been 9% lower in 2000, while a Credit Suisse First Boston study estimated the drop at 13%. This downward effect would have been much greater at many technology companies, for example 30% at Lucent Technologies and 26% at Cisco Systems. The arguments for and against are:

• Business says stock options are not cash payments to the employee, and therefore are not costs. Opponents say that stock options are just another noncash cost (like depreciation) to the firm which come out of their earnings (when the company sells the stock at a lower price rather than at the higher market price).
• The Coalition to Preserve and Protect Stock Options says that changes would "discourage broad-based, rank-and-file access to stock options." However, if stock options do effectively align employees' interests with those of the firm it is difficult to understand why their accounting treatment should differentiate between those issued to executives and those issued to other employees of the firm.
• CPPSO also says that changes "will raise taxes on companies issuing employee stock options." Proposed changes (e.g. Levin-McCain) do not end the tax deduction, but require that those companies which take the tax deduction also include the stock options as a cost of doing business. Thus the real effect of the changes would be to lower companies' profit numbers.
• Opponents argue that accounting for stock options will adversely effect profit figures, which in turn would lower stock prices. In answer Greenspan has said "If investors are dissuaded by lower reported earnings as a result of expensing, it means that they were less informed than they should have been. Capital employed on the basis of misinformation is likely to be capital misused"   Receiving stock options means that executives get the right to dilute the ownership interest of existing shareholders at some future point, in which case existing shareholders will thus get less of the upside potential of the stock than in the absence of the options. In a perfect market existing shareholders would have sufficient information to value when and how this might happen and they would then incorporate that information in their assessment of the value of a company's shares. However, expecting everyone wishing to buy shares to examine in detail every aspect of a company's financial situation in order to evaluate this would impose unacceptable transaction costs that would have detrimental effects on the capital markets and the economy. This is why accounting standards need to require that the maximum amount of information be provided, to reduce transaction costs, improve resource allocation, increase investors' confidence in the markets, and result in a smoothly functioning market.
• Business argues that it is very difficult to value stock options accurately. It is true that this is difficult, but it is not impossible. Various models exist to value options e.g. Black-Schloes. Businesses estimate the value of options themselves, during internal planning and while granting options. Investors should have the same option. Business argues that these would only be estimates, and thus would be misleading to investors. However there are many other items on the financial statements that are estimates, such as depreciation estimates of the decline in market values of a company's assets. Opponents of change are in the curious position of arguing that shareholders are capable of combing through pages of financial statement footnotes and making an informed judgment, but would be confused by imperfect estimates provided by accounting rules.
• On a slight tangent, another factor that might make a difference in how this issue is eventually resolved is the increasing convergence between International Accounting Standards (IAS) and the US Generally Accepted Accounting Principles (GAAP). The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) are increasingly trying to standardize accounting standards (though often their approaches are very different e.g. the IASB approach is "principles-based" while the FASB approach is "rules-based", etc.). The IASB says options should be expensed, and this might weigh in the US decision.

"What's at stake is really the model of granting options that has fueled the growth of tech companies, Silicon Valley's economy and the economy of the country" - Kim Poelese, Marimba chairwoman.
"This threatens the treasured American system of creating rewards for taking risks" - John Doerr, venture capital.
"Levin-McCain would deprive investors of information about stock options and reduce the availability of broad based stock option plans" - Joe Lieberman (D-CT)
"You don't want Congress writing accounting rules" - Liz Fender TIAA-CREF
"Most Hill staffers have never been compensated through stock options, have no idea how they work and probably think they are an automatic boondoggle. As you talk them through the facts of stock options, you can see the lightbulbs turn on as to why the current system works better than Levin-McCain" - Christopher Jankin, Sum Microsystems lobbyist.

Enron and stock options:

From 1996 to 2000 Enron's earnings were $600 million higher than they would have been if stock options were an expense. The tax deductions from those stock options helped Enron pay no taxes during four of the five years in that period. "There are cases where you can use equity to impact your income statement... the most egregious, or the one that is used by every corporation in the world is executive stock options... essentially what you do is you issue stock options to reduce compensation expense and therefore increase your profitability." - Jeffrey Skilling, former-CEO of Enron, testifying before the Senate.

Note: 498 of the 500 firms in the S&P500 account for options by putting them in the footnotes and taking a tax deduction - the 2 exceptions are Boeing and Winn-Dixie.

© SNi 05/12/02