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The Expensing of Stock Options
Brings Both Positives and Perils

By Art Berkowitz and Richard Rampell
August 15, 2002
 
 

Everyone except Osama bin Laden has talked about how to account for stock options, but that doesn't mean there isn't more to say. In fact, much of the options debate has become so shrill that we've lost track of some basic facts.

First, history indicates some legitimate reasons why, at least until now, it's understandable that we haven't expensed stock options. Second, given the current value of many stock options in this vicious market -- next to nil -- expensing them might not cause the tremor some expect. Finally, in the rush to expense options before a standard has emerged, we may wind up with even bigger problems trying to compare company financials.

The options discussion isn't new. The Financial Standards Accounting Board put Statement No. 123 into effect in 1995 after a ferocious debate on how to account for options. No. 123 required firms to account for their stock-option expense in the footnotes to the financial statements rather than in the income statement. At the time, that was a big step. Today it seems a bit small.

Getting Less Optional

But context is everything. At the time, the number of people calling for the expensing of stock options wasn't large. Moreover, international accounting standards hadn't addressed the issue. The U.S. was talking about being a lone wolf in the international community by changing the method of accounting to require stock options to be expensed directly on the company's income statement. Finally, most companies had limited experience in valuing those options. Many companies had only recently adopted broad-based stock option programs to align the interest of their employees with those of the company. This was (and is) a good thing.

But much has changed. Questions about aggressive accounting practices have increased the call for more clarity on financial statements. The global community has joined in, with the International Accounting Standards Board planning to recommend a uniform international standard requiring companies to expense options on their income statement. The European Union is expected to adopt those standards shortly.

Also, because of the footnote disclosure requirement in FASB Statement No. 123, companies have gained considerable expertise in valuing stock options since the initial adoption in 1995.

The most vociferous critics of the present standard -- FASB 123 -- argue that the method of payment shouldn't determine the accounting treatment. Payments made to an employee in cash are treated as an expense, but payments made in the form of options aren't recorded at all until exercised. They contend that the fallacy of the accounting is obvious.

Warren Buffett, in his 1998 letter 5 to Berkshire Hathaway stockholders, asked three questions:

"If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

That argument, however, isn't as overpowering as it sounds.

Murder by Numbers

There is no guarantee that stock options will ever be exercised. Just ask any of the dot-com or telecom employees who are "under water" with most of their options. And since 1995, companies have been required to disclose the effect on their earnings of the unexercised options - providing a relatively simple calculation for analysts and investors to determine the dilutive effect of the options. If that wasn't enough, Standard & Poor's is now calculating "core earnings" assuming the full dilution from the exercise of the options.

So, given those existing measures already in place, requiring stock options to be expensed on the income statement may not really be that big a deal. Of course, experts felt much the same way about the new goodwill impairment accounting standard -- thinking no big surprises were in store. But when AOL Time Warner took a $50 billion goodwill writedown, everyone sure seemed surprised.

Perhaps the thorniest issue involving the headlong rush to expense stock options is a decrease in financial statement comparability. Since some companies have begun to voluntarily expense their options in an attempt to garner investor support for their "conservative accounting," we now have a situation where similar companies may be treating the exact same transactions in very different ways. 6 In addition, there's no uniform standard and FASB said it will permit companies to retroactively restate prior year's options, a policy not permitted under FASB Statement No. 123.

The confusing array of standards will ultimately hurt more than help the frayed accounting system. It's vital that FASB swiftly adopt standards that will harmonize the various expensing methods companies are choosing. That way this rush to expense stock options will have a more substantial -- and welcome -- impact on improving the coherence of financial statements.
 
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