OPED24 Accounting for Stock Options

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:

In conclusion this OPED believes that the accounting treatment of stock options should change - that when granted they should be valued and treated/reported as a cost of doing business. While this valuation would not be one hundred percent precise, it would be a move to increase transparency that would have positive effects on the market. The scare tactics of opponents (see some quotes below) should not derail attempts to bring about changes in this area.

"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