Accounting in the new Market
stock price, (1) investors will be dissuaded to pump cash into the given company, (2) employees will not find stock options as attractive, and companies will curb use of options for employees.
The high technology sector is the most vocal in its opposition to expensing options. Stock options make up the majority of compensation for employees because they do not have the cash needed to attract and pay quality people (they are relatively new, start-up companies). Options are used as a promise for big money in the long run. Small high-tech companies believe that they will be placed at a competitive disadvantage with larger companies that can withstand higher compensation charges in the short run. 1 The impact on profits for larger companies is equally significant. A study of Microsoft, the world's largest corporation based on market capitalization, found that its 1998 profit of $4.5 billion would actually have been a loss of $18 billion had its stock options been treated as wage expense. 6
In response to this opposition, which was based primarily on economic consequences arguments, the FASB decided to encourage, rather than require, recognition of compensation cost based on the fair value method and require expanded disclosures. 1
Not all companies agree that expensing will cause significant damage. Many are beginning to make the move towards expensing. 7 "The tech community is one voice being drowned out by an entire chorus of voices supporting expensing," an economist recently said, adding that General Electric and about 120 other companies have pledged to begin reporting stock options as an expense. 4 Most of these companies, though, will see very little impact on their earnings per share because they don’t have the large amount of options outstanding that high-tech companies do.
II. Valuation of Options
Opponents of expensing complain the current methods used to determine the value of employee stock options are flawed and subjective. Opponents contend many press reports on the options controversy convey an impression that valuation is a simple matter of plugging numbers into a well-accepted model. It is not that straightforward. 2 Option valuation models require the input of highly subjective assumptions including the expected price volatility of the stock. Because the options granted to employees are not tradable and have long contractual lives and changes in the subjective input assumptions can materially affect the fair value estimate, the models do not necessarily provide a reliable measure of fair value of the option. 8
For example, the Black-Scholes option pricing model most commonly used to value options was not intended to handle employee stock options. It was designed to value readily tradable stock options with relatively short lives and no vesting restrictions. Employee stock options cannot be traded and are lost if an employee leaves before they are exercised. Opponents argue both of these [next page]