Accounting in the new Market
financial picture of employee compensation expense. Although the option grants are currently disclosed in the footnotes to financial statements, they don't affect reported earnings when they are issued or when they vest. As a result, the current accounting treatment of options leads to higher reported earnings, with the negative impact on earnings arriving years later when the options are exercised. 3
To illustrate this point, Merrill Lynch recently calculated that profit at 32 companies in the chip industry would have declined 69 percent on average in 2001 if they had expensed options. Intel, for example, would have had net income of $254 million instead of $1.3 billion. 4
Expensing stock options would move earnings closer to a true earnings figure. Stock options are compensation for employee services, and compensation should be reported as an expense. Alan Greenspan recently commented, “I fear the failure to expense stock option grants has introduced a significant distortion in reported earning-and one that has grown with the increasing prevalence of this form of compensation.” 5
II. Informed investors
Investors have recently been burned due to financial misconduct by several companies. This makes investors leery of information provided by companies about their financial standing. It is important to boost investor confidence (for the sake of our economy) by providing a full and accurate picture of a company’s financial position. Since options do not currently show up on income statements (reported as zero then included only in the footnotes), it may appear companies are hiding pay. 2 This is not the way to regain the average investor’s trust. By expensing, we may move reported earnings closer to true earnings and make general investors more aware of their effects on income. By excluding, investors are less informed than they should be about the true input cost of creating corporate revenues. Alan Greenspan said in his May third speech: “Capital employed on the basis of misinformation is likely to be capital misused.” 5
He also made these comments to further support this point: “In recent years, substantial capital arguably was wasted on a number of enterprises whose prospects appeared more promising than they turned out to be. This waste is an inevitable byproduct of the risk-taking that generates the growth in our economy. However, the amount of waste becomes unnecessarily large when the earnings reports that help investors allocate investment are inaccurate.” 5
The ‘cons’ of ‘expensing’ stock options
I. Damaging to companies
Some companies contend that if they are forced to expense stock options, (1) raising capital will become more difficult and (2) the use of options as employee compensation will decline sharply. The logic is this: Expensing causes lower reported earnings, and the lower earnings can cause a lower stock price. Due to the lowered stock [next page]