Options to Expense 

Financial Management

Options to Expense

The issue of whether to present employee stock options as an expense on the financial statements has caused a rift in the accounting community along the lines of relevancy vs. reliability.

FROM: MAY-JUN 2003 ISSUE | BY DEREK STROCHER

Many of the world's accounting bodies, securities regulators and analysts have recently called for greater transparency in the cost of granting employee stock options. While this appeal is not new, the ineffectiveness of the current FASB rule (SFAS123, Accounting for Stock-Based Compensation ) to create cost transparency for employee stock options, coupled with a renewed vigour to toughen accounting rules in the wake of recent corporate scandals, has again brought this issue to the forefront of the accounting world. Advocates for relevancy are pitted against supporters of reliability.

Employee stock options are call options that corporations issue to their employees (mainly to management) on the company's own stock (generally common shares). Each employee stock option confers the right but not the obligation to purchase a company share, at a pre-determined price (the exercise or strike price), on or before a specified expiry date. Employee stock options gained favour with corporations and investors alike as a way to compensate management because they supposedly tied management's gains directly to those of the company. The idea was that management would be highly motivated to make business decisions that increased the company's share price, thereby making positive returns for investors, because that share increase also raised the value of their own stock options.

While the logic for compensating employees with options seemed sound, the explosion in the issuance of stock options in recent years has created problems for the very same investors that favoured their adoption. These investors are now finding a lack of transparency in labour costs, which is hampering their ability to judge corporate performance and make meaningful comparisons among companies.

Take, for example, two identical companies, A and B (tax and time considerations aside). The only difference between the two is that company A uses cash to pay its employees while B uses the equivalent amount in stock options. Company B will have higher earnings because it has no salary expense and appears to the average investor to be more profitable. To see that these firms are actually in identical financial shape, the average investor has to evaluate information from company B's note disclosures regarding the cost and dilution of employee stock options. Average investors tend to discount this, if they assess it at all.

Relevancy

One of the first prominent businessmen to recognize the relevancy of employee stock options as an expense was Warren Buffett. His logic was simple: giving something of obvious value to employees in exchange for their work is called compensation, regardless of its form. Since other forms of compensation are included in the calculation of earnings, he argued, why not employee stock options? Buffet's point is difficult to argue with. Clearly any employee who receives stock options would place some value on them. If the income statement item "labour expense" reflects the cost of labour, certainly it should include this cost as well.

Shareholders who observe the cash effects of employee stock option issuance first-hand would surely agree that these options are relevant to the calculation of labour expenses. While there is no initial cash cost to the firm for issuing employee stock options, each time one is exercised, the firm's value is diluted among more shareholders. Since employees will exercise their stock options only if the strike price is below the market price, the original shareholders lose real cash value on their holdings.

Even without this cash effect, the failure to expense stock options is inconsistent with some principles of GAAP. GAAP is an accrual-based system used to measure and report a company's relevant financial condition, which includes the cost of its employees at the time it compensates them. A company must accrue an employee stock option expense at the time it grants one (the grant date) to accurately reflect the market price of labour, which would enable meaningful cross-company comparisons. Making an estimate of the cost of an employee stock option is as relevant as estimates for pension costs or the myriad other estimated costs. All of these estimates are essential to forming the best guess of the firm's financial state as reflected in the financial statements.

Reliability

The conflict between relevance and reliability centres on this need to estimate. Advocates for financial statement reliability consider the proposed methods for estimating and accounting for employee stock option expenses to be inadequate. Without a high degree of reliability, a shadow of doubt is cast on the entire option expensing process.

Current proposals put forward by the IASB and other accounting organizations suggest that firms should use an option-pricing model, such as the Black-Scholes model, to estimate the value of the employee stock options they are issuing. While these models are excellent at valuing exchange-traded options, they are generally inadequate at pricing unique securities. And attempts to adjust them also fall short. These traditional models are constrained by time, liquidity and re-pricing issues.

The time constraint has been expressed in various ways, including vesting and holding periods, but the most worrying aspect of this constraint is blackouts. Employees are subject to insider trading regulations that create blackout periods when they are prohibited from exercising their options. These blackouts make it difficult to assess the term of the option, as well as measure its volatility. While the volatility of exchange-traded options is implied through their market pricing, the volatility of employee stock options needs to be measured in order to determine a price (an amount to expense).

Measuring the volatility of stock prices that are restricted by blackouts is extremely difficult. The problem lies in the inability to predict when insider information and blackouts will occur. Some blackouts are plainly evident, such as the period leading up to earnings announcements; however, many will occur as a result of a conversation, an idea or a strategy that develops within the firm. These more elusive blackouts are nearly impossible to measure with foresight but they have a real impact on the theoretical value of employee stock options. Models cannot properly account for blackouts because of this instability.

The second major constraint on employee stock option valuation is that no liquid market exists for their trading. In nearly all cases, employees must exercise their stock options, rather than sell or replicate them, to realize their value. Exchange-traded options do not suffer from this same burden because of their standardization of terms and their existence in a trading environment. Other liquidity constraints, such as placing limits on the number of options that a manager can exercise in a year, impair the overall value of stock options. Although difficult to quantify, these liquidity problems, which traditional models do not account for, reduce an option's value to some extent.

The third constraint in measuring employee stock option values is the practice of re-pricing. It is common for corporations to reduce the exercise price of employee stock options following extreme and/or prolonged stock price declines. Accordingly, there is additional value inherent in these options from their inception. An option that could be re-priced at some future date is worth more in an open market transaction, all else being equal, than an option that couldn't be re-priced. Traditional models like Black-Scholes do not account for this extra value in the initial pricing of options.

A reliable estimate of an employee stock option expense is critical. Unlike estimates for pension costs, which can endure inaccuracy because they are continuously adjusted as more or better information comes to light, employee stock option expenses will receive no such reassessment. Proposed rules call for selected adjustments to shareholders' equity for exercised options only, with no corrections to the income statement for either exercised or expired options. Forfeited options are the only ones that would be fully corrected. Therefore, poor estimates of stock option expenses may become embedded forever in the financial statements. Clearly you need to scrutinize the cost estimate of an employee stock option more closely than other estimated costs.

Given the need to accurately estimate employee stock options and the inability of current option pricing models to do so, proponents of reliability suggest that current methods of note disclosure are the best way to handle them. Rather than have their earnings subject to permanent estimation errors, which corporations see as having a direct effect on stock prices, they urge keeping that potential error in the notes. Consequently, they would like to place more emphasis on the notes, not less. A high-profile item like employee stock options is exactly what is needed to focus investors on note disclosures.

A New Model

The financial community widely accepts Warren Buffett's relevance argument. Employee stock options are indeed a form of compensation. If comparability among companies is a goal, accountants are going to have to do a better job in reporting employee stock options. That means finding a more reliable way to value them, not simply trying to adjust the limitations of traditional option-pricing models.

One potential solution is to shift the focus from trying to value the option to trying to value the labour cost and then equating the two. There already is widespread consensus on using this approach for option payments in commercial transactions. The value of the options is deemed to be equal to the value of the goods received in exchange. If it is more accurate to measure the labour cost than the option cost, this method could provide the necessary reliability.

To determine the value of stock options to employees, you first need to understand how they think about compensation. Typically people are not applying complex pricing models to value their compensation. They are pricing stock options at some average of what they have observed the options to be worth in the past.

Advocates for using this approach suggest that companies should examine their historical records, or those of similar companies, to determine the gains their previously issued stock options returned to employees over an appropriate time (likely matching the option's expiration period). This theory implies that, on average, employees will expect future stock options to return similar amounts. They will then adjust their estimates over time as they see their options realizing more or less value. While this contradicts financial theory that suggests past averages are a poor predictor of the future, it is plausible that employees use the past as a significant measure of a stock option's worth. Since you are trying to understand stock option values on the grant date from the employees' perspective, perhaps the past is just where you need to look.

Of course this theory has its difficulties as well and certainly is not applicable for all firms. In reality there is no absolutely reliable model to help value employee stock options. They exist in an unfamiliar marketplace where the laws of arbitrage, liquidity and time are ambiguous and where the ability to change terms in mid-stream is commonplace. This, however, does not alleviate the need for relevant financial statements that are transparent and allow comparability.

The need to expense employee stock options to establish relevance is real. The search for a reliable method to do so continues.

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Derek Strocher, M.Sc., CGA, is the senior financial analyst in corporate finance for Nexen Inc., one of Canada's leading international energy companies.