Employee Stock Options Must be Treated as Expenses 325
currivan writes "In a move that's been in consideration for a long time, the Financial Accounting Standards Board (FASB) approved new rules requiring employee stock options to be treated as expenses for reporting purposes. One of the reasons so many tech companies have given options to IT/engineering workers is that until now, they haven't counted against profits in quarterly reports. If markets were truly efficient, this wouldn't make a difference, but in reality, the tech industry is strongly opposed to the rule, though it should please Warren Buffett."
How will it work? (Score:4, Interesting)
Can someone confirm how this really works? When options are granted, it is usually an option to buy a certain number of shares at today's market value. So on the day of the grant, the value is usually always 0.
Let's say an option is granted to buy N shares and a year from the date of the grant, the stock is up by 10 points - then the value is then 10 x N. So the company now needs to subtract 10 x N from its earnings for the fiscal year during which the stock was up by 10 points? Then next year it goes up again and the company adjusts earnings again? Ad infinitum?
OR does the company just make a speculation, something like "we think the stock will go up by 10 points this year, so lets just subtract 10 x N from earnings". But what about the value 10 years from now?
What happens with taxes? It is advantageous for a company not to ever show any profits, this seems like a simple way to reduce your taxable income as far as the IRS is concerned. Most corporations don't pay any taxes anyway, but now this just got easier: "Let's grant everyone a bunch of options that we deem are worth 10 bazillion"?
Lastly, I don't see how this rule will affect anything at all since more likely than not companies will just be publishing two numbers - earnings with stock option adjustment and without. Kinda like EBDTA.
Re:Hmmmm (Score:2, Interesting)
Re:Hmmmm (Score:3, Interesting)
Of course you would. Hence it is a real expense. If it wasn't a big deal it wouldn't be a big deal.
Easy answer for those it matters to: (Score:1, Interesting)
If you liked receiving stock options: This is bad for you.
If you didn't like receiving stock options: This might be good for you.
This basically makes the disbursement of stock options to employees cost as much as giving cash. If you liked receiving stock options, you will be probably be disappointed because companies do not have the incentive to give them that previously existed. However, I only said that this might be good for you if you didn't like receiving stock options. Whether you like them or not, stock options do have the potential of being very profitable for you. If the expense to the company is very low, they will not have too much trouble handing them out as bonuses and such. Now, with an expense tied to giving stock options and with as tight as companies are currently, these stock options may begin to try up only to be replaced by...nothing. IANAEA (economic analyst) but as far as I can tell, we are still in employer's market or possibly close to a balance, thus, large bonuses to attract employees are not currently in force.
The Microsoft Story, case in point (Score:5, Interesting)
In case you haven't heard [billparish.com], Microsoft (MSFT [yahoo.com]) has been deeply unprofitable [economist.com] since 1996, when it began to rely on holes in the GAAP accounting standards that allowed it to report historic profits in its NASDAQ filings. Large fund managers bought into it to the tune of hundreds of billions of dollars, making MS at its peak ($700B [billparish.com]) which for comparison made it the largest component of the S&P 500, the equivalent of the 16th largest country [cia.gov] or ~1.5% of the GDP of Earth. Though billed (no pun intended) as a success story, when the bubble burst investors lost billions.
Who cares? The biggest funds involved were pension funds of large social programs across the US, e.g. the California Teachers Union, who automatically invest in S&P components at rates proportional to the components' value. MS paid for its bottom line with those peoples' money, so much so that pensioners are majority owners of MS today. Too bad for them that the bottom fell out of MS stock and their savings are worthless. But it did help create two of the richest personal accounts on Earth [nwsource.com].
You could argue that this was all legal and that they won the king of the hill prize. Perhaps. But is it ethical to block GAAP reforms via corporate shills in Congress (e.g. Joe Lieberman) [portlandtribune.com] so your huge losses won't be exposed? Enron execs are being hung out to dry [alwayson-network.com] for being only slightly on the other side of that thin line in the sand. No, it's likely MS knew what it was up to. As Bill Parish, who broke the story, tells:
"Microsoft's perspective is best reflected by Bob Herbold, Chief Operating Officer, to whom the CFO reports. Bob very sincerely [explained the situation to Gates], "Bill, everyone is doing it.""
This is a great vindication for Bill Parish, and another step towards reigning in widespread corrupt accounting practices. http://freality.org/~pablo/essays/microsoft.htmlDodgy Accounting (Score:2, Interesting)
Stock options are not granted by the company. They are granted by the shareholders. Every stock option grant I recieved, even from a small, no longer here startup, was granted by the board of directors, not the executives of the company.
The shareholders of the company basically offered me a deal that if the stock price of the company is greater than the strike price, then they would allow me to purchase shares of the company at some strike price. Essentially the shareholders of the company incurred a future liability equal to the number of shares times the difference between the actual price of the stock and the strike price.
HOWEVER, rather than show this liability on the books of their investment business, investors shift the potential future cost of the options back to the company. Remember a corporation is a legal entity, so what we have is a shift of liability from one legal entity, the shareholders or venture capital firm, to another legal entity, the corporation.
Interestingly enough this is exactly how Enron worked. Enron created a large number of shell corporations and made Enron's books look better by shifting income to the parent corporation and shifting liabilities to the subsidiaries. This is a classic technique in fradulant business practices, namely moving liabilities off of the books of one corporation. But I digress...
Back to the issue at hand. Institutional investors, rightly, are annoyed that these future liabilities aren't accounted for properly. Unfortunately, their mechanism, is flawed. Ideally, the liability of future options would be shown directly on the books of the owners of the company, not on the company itself. The investors aren't going to do that as it makes their investment business financials look bad.
Given that the shareholders shift the burdon of funding exercised options to the company, then this liability should be treated as a future debt, not like a current expense. When a company takes a loan, they expense the payments as they are made, not the entire amount of the loan up front.
Stock options are not an expense. They are a debt instrument, like a loan and should be accounted for as a liability on the balance sheet and expensed when the options are excercised and paid off. At that point, you remove the options from the liability side of the balance sheet.
Re:Hmmmm (Score:2, Interesting)
But your labor _was_ bought w/ options.
With the zero-value option theory, if a company wanted to show zero expenses, all they would have to do is pay for everything with options. Options are easy enough to value, especially compared to many other goods. There's not a perfect way to value them, but there's not a perfect way to value anything.
The fact is that the options were used as payment for services, and if they didn't receive options they would probably have requested some other kind of compensation, another clear indicator of value. If the employees didn't value the options, why go to the trouble of giving them?
The valuation is still wrong (Score:5, Interesting)
Putting a value on those options is itself a matter of some contention. Basically, employee stock options (ESO) nearly always have a strike K bigger than the current stock price S when they are granted. The value of the option lies in the fact that it is reasonably likely that at some later date, K>S.
So, a foolish measure of value would be intrinsic value: i.e. MAX(0, S-K). There is a formula called the Black-Scholes formula used for pricing options with only one allowable exercise date, and no other special features. That formula is quite inappropriate for pricing ESO, since ESO come with lots of other quirks, including vesting periods, stock holding periods, employee attrition, and (not least) lengthy time intervals in which they are exercisable.
Of course, to accountants even the BS formula is exotic. Rather than using a proper model (hinted at in FASB 123 with the moniker "binomial model") to price the options, accountants prefer to use BS, and then "adjust" the results as they see fit to account for the various features. The results of this are better than just using intrinsic value of course, but not by much.
I developed a model for the bank to use in pricing its ESO. It was reasonably correct, in the sense that it used the traditional approach of a trinomial tree to model the stochastic process followed by the stock price, along with code to account for the various quirks of our options. It still had manipulable inputs, such as volatility, but at least accountants would have to have justified their values.
Of course, internal politics killed the model in favor of the BS formula, and arbitrary accountant's adjustments. If that's what happened in a major bank, with the generally stated goal to transparently publish numbers, and with guys like me around to develop models like that...well, how much are you going to be able to trust the option expenses published by other companies?
I hope that FASB fixes this, and deprecates the use of the BS formula in inappropriate contexts.
Accounting is Not Mathematics! (Score:2, Interesting)
Some other accounting favorites...
Accounting vs. Math/Statistics
Accounting Variance = Mathematical Difference
Accounting Volatility = Mathematical Variance
Whatever accounting is...it is not math, I am convinced.
Re:Hmmmm (Score:2, Interesting)
You can win if you want. Anybody who's been watching politics in any country lately should be able to see you don't have to be correct in order to win.