Accounting in the new Market
For my sake, let’s begin with some basic questions:
What are stock options? A stock option is a warrant (certificates entitling the holder to acquire shares of stock at a certain price within a stated period) which gives selected employees the option to purchase common stock at a given price over an extended period of time. 1
Why do companies give employees stock options? Stock option plans are used to pay and motivate employees. They are very popular because they meet the objectives of an effective compensation program. 1
What is an effective compensation program? It is one that (1) MOTIVATES EMPLOYEES TO HIGH LEVELS OF PERFORMANCE, (2) HELPS RETAIN EXECUTIVES AND ALLOW FOR RECRUITMENT OF NEW TALENT, (3) BASES COMPENSATION ON EMPLOYEE AND COMPANY PERFORMANCE, (4) MAXIMIZES THE EMPLOYEE’S AFTER-TAX BENEFIT AND MINIMIZES THE EMPLOYEE’S AFTER-TAX COST, AND (5) USES PERFORMANCE CRITERIA OVER WHICH THE EMPLOYEE HAS CONTROL. 1
How do stock options specifically meet the objectives of an effective compensation program? Since compensation is directly related to performance of the company’s stock in the long run, employees are motivated to work hard and make the company as successful as possible.
Aren’t options already expensed in company financial statements? Under the intrinsic value method used by most companies, options are computed for inclusion as compensation expense. The problem is most options are reported at zero (discussed under calculating the expense section), implying they have no value and, therefore, no effect on net income. The debate arises from the FASB’s push to use the fair value method, which will assign a definite cost to the use of options as compensation expense. This will, in effect, adjust net income based on the expense. When we read about the push to expense options, we are really reading about the push to switch to the fair value method. From this point on, we will assume ‘expensing’ in the context of this paper actually refers to using the fair value method to expense options.
Why all the fuss over “expensing”? The bottom line is: The bottom line! Expensing causes lower reported earnings, which in turn, causes lower earnings per share and, ultimately, lower stock price. The employees holding options want the stock price to be at maximum value when they exercise (cash in) those options.
The ‘pros’ of ‘expensing’ stock options
I. Accurate financial information
Stock options are designed to align employee and shareholder interests while providing everyday workers with a stake in the system. Unfortunately, stock options have recently been used to disguise costs, provide excessive rewards to people already excessively rewarded, and give CEO’s a reason to play games with earnings. 2 In a post-Enron, World-Com, and dot-com investment environment, there is a demand for accurate and reliable financial information. Investors are looking for useful information that can help them make good financial decisions. By expensing stock options, we are providing an accurate financial [next page]