Download MBA 661 Debate 4

MBA 661
Debate 5
Executive Summary
Topic: Stock Options: To Expense or Not To Expense
Teams Bravo and Golf
Debate took place March 4, 2004 at 5:30 p.m.
Topic: Stock Options: To Expense or Not To Expense
Points to consider:
A stock option is a method of employee compensation that gives workers the right to buy the company's
stock during a specified period of time at a stipulated exercise price. In recent years, offering top
executives stock options as compensation has become increasingly popular.
The importance of stock options as a part executive compensation increased following a provision of a
1993 U.S. law that limited business tax breaks for high level executives’ compensation over $1 million.
Stock options and similar performance based pay do not fall under this provision, hence the excessive and
sometime abusive use of stock options for executive compensation. Stock options also aim to align
executive pay with the company’s performance and the ability of the leadership to increase shareholder
wealth.
Currently, companies are only required to declare options as a footnote to the expense reports and declare
diluted earnings per share which takes into account all outstanding options per the Standards Board
(FASB) in October 2003. As of November 2003, more than 300 companies had adopted this policy.
The expensing of options should not unilaterally affect U.S. companies or place them at a competitive
disadvantage to the international community. The International Accounting Board (IASB) in London
favors expensing options and is developing standards for global corporations. There is a desire by all to
converge standards therefore the playing field shall be level.
Team Bravo supports expensing stock options:
o
o
o
o
o
Not declaring stock options as an expense provides an unclear financial picture. A Federal
Reserve study found that corporate growth would have been 5% and not 8.3% if options had been
expensed. Merrill Lynch found that earnings for 2001 would have been 21% less for the S&P 500
and 39% for technology companies. Yahoo! reported a profit of $71 million in 2000, but after
stock option expensing a loss of $1.3 billion. Cisco’s $4.6 billion profit would have been a 2.7
billion loss. Is this reality? Or is it excessive inflation of stock prices based on the reported
numbers. Would the Internet/technology bubble of the late 1990s even occurred if stock options
were expensed? Stock options don’t have a direct cost therefore they shouldn’t be expensed.
Right? Well as Warren Buffet stated, “If stock options aren’t a form of compensation, then what
are they? If compensation isn’t an expense, then what is it? And, if expenses shouldn’t go in the
calculations of earnings, then where in the world should they go?”
Stock options dilute the value of the earnings. The value of stock options comes partly at the
expense of the shareholders. Options have value. Every stock option granted is a share that could
have been sold to investors raising capital. There is value to these options. This value has been
presumably captured in the diluted earnings per share price. But this is via a footnote that can be
unclear, not completely transparent and, because of the afterthought nature in which is depicted,
not given as much credence by investors as the earnings per share figures.
Corporations receive tax deductions for the compensation they provide executives when they cash
in stock options which could mean paying no taxes at all because the tax liability erased through
stock options expenses may not e subject to the corporate alternative minimum tax. A loophole in
the 2001 IRS Revenue Ruling 2001-1. Clearly this is a double standard that fuels incentive to use
stock options as compensation.
Executives become focused on stock price and accounting tricks to keep stock high. The initial
intent of stock option awards was to align compensation with company performance but this has
not exactly worked out as initially intended in some cases. Creative executives can artificially
inflate earnings by reducing expenses such as R&D or hiring or through other investments while
compromising long term goals, real company growth and ultimately shareholder wealth.
Stock options awards are usually top heavy. 30% of the stock options go to the top 5 executives
of corporations and 70% go to other high level employees. Stock options account for
o
approximately 60% of executive pay and that pay has grown from 100 times the average worker
10 years ago to more than 500 times the average worker today. Clearly the government’s goal to
reel-in executive salaries and the related abuse has backfired and should be revisited.
High powered individuals support expensing.
o Warren Buffett
o Alan Greenspan
o 80% of U.S. Financial Analysts
o Arthur Levitt (Former SEC Chairman)
o Council for Institutional Investors
o Senators Carl Levin and john McCain
Team Golf supports not expensing stock options:
o
o
o
o
o
o
The growing controversy over whether stock options should be expensed on a corporation’s
financial statements has really grown out of investors distrust of the accounting practice of
corporations, such as Enron, and not out of a real need for investors to know the true financial
costs of stock options to a company.
Therefore, we believe that corporations should not be required to report stock options as a
compensation expense. In the following we will seek to further explain our main reasons for our
position on this issue.
The first reason: Corporations already provide this type of information to investors as a footnote
on the financial statements and is readily available for any concerned investor.
The second reason: Expenses that are being reported are completely flawed in their value because
the formula contains several variables that can change over the life of the option. One variable
for example, is the risk-free rate. The formula assumes it stays constant over the life of the
option, however in the just the last two years this rate has bounced between one and four percent.
Also, not considered, is the fact that some employees never exercise the option so the expense
would have been unjustly recorded.
The third reason: Reporting options incorrectly as an expense could actually cause irreparable
harm in the US economy, especially with the stock market in a very fragile state. By reporting
this incorrect negative information, the stock market would devalue these corporations, which
may hurt stockholders across the entire market.
Finally this may also cause corporations to stop issuing stock options all together. If this were to
happen, new entrepreneurial companies would have a very difficult time in attracting the most
talented executives from their industries, without already having strong cash positions to pay very
high salaries.
Debate Summary:
Both sides agree that although options are a form of compensation but are difficult to value.
There are other forms of performance-based compensation that should be considered. Other forms of
compensation can be implemented in lieu of options such as grants, bonuses and money although those
have not been shown to be very effective long-term motivators. The astronomical value that options have
achieved has clouded the perspective of some and a number of corporate scandals have erupted. The
initial aim of stock options to build shareholder wealth has backfired in some instances.
The playing field should be level for all companies including internationally based corporations
in the coming years as the expensing of stock options becomes law in 2005 and the IASB will likely
institute similar standards. Initial public offerings of young upstart company may be hindered by the
expensing options but innovation will undoubtedly persist.
Companies, like IBM with their premium option program, will continue create reward structures
aimed to motivate employees and increase shareholder wealth. Hopefully the new stock option expense
law will ultimately make the entire process easier for all parties involved and fair and equitable system
will evolve.
References
“Stock Options Revisited”, Rue, Volkan, Best and Lobo, The CPA Journal
http://www.nysscpa.org/cpajournal/2003/1103/features/f113403.htm, November 3, 2003.
“Options Grow Onerous”, Lavelle, Borrous, Hoff and Weber, Business Week Online,
http://www.businessweek.com:/print/magazine/content/03_48/b3860034.htm, December 1,
2003.
“Financial Accounting & Reporting”, Association for Financial Professionals (AFP), Tuthill,
Maureen, July/August 2002, p. 7-12.
“Last Hurrah for Stock Options”, http://www.wired.com/news/print.html, February 5, 2004.
“What Stock Options Are and Why They Should Be Expensed”,
http://www.citizenworks.org/corp/options/talking-points.php, 2002.
“What Opponents of Expensing Argue and Why They Are Wrong”,
http://www.citizenworks.org/corp/options/opp-arguments.php, 2002.
“IBM’s New Stock Option Plan Gets Applause”, Morgenson, Gretchen, Seattle PostIntelligencer Online, http://seattlepi.nwsource.com, March 1, 2004.
“Intel, Cisco Fight Options Expense”, Jander, Mary, Light Reading Online,
http://www.lightreading.com, August 8, 2002.
“Stock Option Options: The Debate Over Expensing”, DeLong, James, Competitive Enterprise
Institute, http://www.cei.org, April 4, 2002.
“Valuing Options As An Expense Adds a Key Vote”, Chicago Tribute Online,
http://www.chicagotribune.com, May 4, 2003.
“Option Compensation Part Two: To Expense or Not To Expense? That Is The Question - - Or
Is It?”, Wayman, Rick, Investopedia.com, http://www.investopedia.com, September 25, 2002.
“The Ongoing Debate Over Whether to Expense Stock Options”, AON Consulting Forum, June
2003.
“Options Expensing: A Political Battleground for Conservatives”, Neal, Jeff, Optionetics.com,
January 27, 2004.