Calling all accountants: proposed new business rules?

[JeffL]

OK, accountants, I'm puzzled by something I see proposed in the new laws for business reporting. Basically, they're saying options should be listed as expenses.

So - how do you value an option? If my company gives me 1000 options at $35, the value of the options is nothing until (and if) I exercise them. If I use them while the stock sells at $40, that's $5000 dollars, if I exercise them when the stock is $36, they're worth $1000. If hold onto them because the stock never goes over the option price and they expire, they're worth precisely $0.

So how is a company expected/required to value these for expense purposes? I'm genuinely puzzled.

[TimElhajj]

I am no accountant but I thought the expense was to be tallied only for exercised options. So when you cash out, that's the charge. I am sure someone will set me straight.

[Reeko]

They are, in effect, selling you an asset well below market value. They would expense the difference between what you paid for them vs. what they would have received in open trading.

[TimElhajj]

They are, in effect, selling you an asset well below market value. They would expense the difference between what you paid for them vs. what they would have received in open trading.

Are you sure about that? I don't understand how that would make sense. It seems like it would be a huge expense on paper--one that often is never even realized at the bank.

It's like a variation of the thing my old man used to say, "if I had a nickle for every option I never got to exercise, I'd be a rich man."

[Troy S Goodfellow]

Well, I'm not too well versed on the technicalities, but there's certainly some way to estimate the worth of options. They do it for tax returns every year, after all.

If it was impossible to do, Greenspan wouldn't be calling for it.

[JeffL]

They are, in effect, selling you an asset well below market value. They would expense the difference between what you paid for them vs. what they would have received in open trading.

But in that case you could only expense them when the option is exercised, because only at that time is there any actual value (the delta between the market price of the stock and your exercised cost for the stock.) That's often 10 years after it's been given to the employee.

And they are talking about expensing these up front - for example, a lot of start-up companies are in a tizzy about this, because they often offer options in lieu of larger salaries, and they're being told they have to expense these up front. Their argument is that they're being forced to claim an expense that may never be real, due to the tenuous nature of the value of value (and future existence) of a start-up.

Again, I am puzzled as to how true value can be assessed before the actual exercise of the option, years after its issue.

[Jason McCullough]

A suggestion I saw that makes sense is valuing the options at the price they would get on the open market. Companies can, and do, sell options on their stock to investors; so the argument is that here they're effectively "selling" the option to the employee, and then giving the money they used to purchase it right back to them.

Clear, concise, and fairly easy to value.

[TimElhajj]

A suggestion I saw that makes sense is valuing the options at the price they would get on the open market. Companies can, and do, sell options on their stock to investors; so the argument is that here they're effectively "selling" the option to the employee, and then giving the money they used to purchase it right back to them.

So then the expense would be whatever your strike price is?

[Reeko]

Are you sure about that?

I'm sorry, I meant that's how it should be done, not how it would be done.


I don't understand how that would make sense. It seems like it would be a huge expense on paper--one that often is never even realized at the bank.


Example:

ABC Inc gives CEO Joe an option to buy 1,000 corporate-owned shares at $10/share. 3 years later, CEO Joe exercises this option and gives ABC, Inc $10,000. Currently, ABC Inc stock sells on the NYSE for $100/share. ABC Inc just sold $100,000 of corporate-owned assets for $10,000. In effect, the company gave away $90,000. This should be marked down as an expense.

[Philo Goodberry]

Here's a great discussion of some of the problems of expensing options:

http://www.morethanzerosum.com/archives/001346.html#001346

Part of it, in short, is that if options are expensed, when they expire, unused (as every option I've ever been granted has been) they have to be treated as a revenue. This could open up all kinds of new ways to play with income statements, and make company books even more complicated and inpenetrable.

[TimElhajj]

ABC Inc just sold $100,000 of corporate-owned assets for $10,000. In effect, the company gave away $90,000. This should be marked down as an expense.

Yep, that's what I originally thought. That options would only be marked as an expense after they were exercised. This way you have a value.

But after looking around a bit, I think I had that wrong. Jeff explains it in his post. The idea is to account for options when they are issued, not when they are ultimately called in.

Interesting quote from the Washington Post (http://www.washingtonpost.com/ac2/wp-dyn?pagename=article&node=&contentId=A33322-2002Jun23&notFound=true):


Accountants calculate values for things whose values are unmeasurable all the time. They have no trouble assigning value to loans that might not be collected, office buildings whose prices rise and fall with the real estate market and interest rates, and all kinds of contracts whose final value will not be known for years.

Calculating the value of options, in fact, is one of the great accomplishments of modern business mathematicians, Blitzer said. "There is very little in financial modeling that has been tested more than options pricing models. There have been a zillion PhD theses written on it."

Now that I think about it, how does this even stop the abuse? Just because there is an expense on the front end, how does that keep an unethical CEO from inflating the value of the company for a short term gain?

EDIT: funky quotes

[Jason McCullough]

A suggestion I saw that makes sense is valuing the options at the price they would get on the open market. Companies can, and do, sell options on their stock to investors; so the argument is that here they're effectively "selling" the option to the employee, and then giving the money they used to purchase it right back to them.

So then the expense would be whatever your strike price is?

It'd be whatever the market price is at the issue for the options themselves, not the shares, since options are the "right to buy at a given price."

Hmm, see if I can explain this: an option is a right to buy an asset at a contractually specified price anytime during the lifetime of the option, regardless of the actual price of the asset. Basically, if you buy an option for four years on say, 1,000 shares of MSFT stock at $45/share, then for the next four years you can pay $45 a share for up to 1,000 shares, and they'll give you the shares regardless of how much they had to pay for them.

You're making an investment decision that at some point in the lifetime of the option, you'll be able to exercise the option (buying the shares for the strike price), immediately sell the shares, and come out with more money than you paid for the option up front. Options function like any other market, so the price you pay for it is whatever the interaction of supply and demand set the price at.

It's actually a lot clearer in gambling terms: the option value is whatever you paid to make the bet. You have to pay that regardless of whether it pays off or not.

Now, on to employee stock options: employees get the option for free, so you can effectively treat an employee stock option as compensation to the employee equal to the value that given option would receive on the open market.

An equivalent way to specify what the company loses in an employee option grant is that the company loses, at the time they give the option they grant to the employee, the cash they could have sold it for to a non-employee. Using the gambling analogy, it's like the company giving the employee some free chips (ignoring the "keep them in the casino" aspect of free chips, which doesn't apply here); it's all downside for the company.

It's an expense, just a way convoluted one.

[Jason McCullough]

ABC Inc just sold $100,000 of corporate-owned assets for $10,000. In effect, the company gave away $90,000. This should be marked down as an expense.

Yep, that's what I originally thought. That options would only be marked as an expense after they were exercised. This way you have a value.

But after looking around a bit, I think I had that wrong. Jeff explains it in his post. The idea is to account for options when they are issued, not when they are ultimately called in.

Interesting quote from the Washington Post (http://www.washingtonpost.com/ac2/wp-dyn?pagename=article&node=&contentId=A33322-2002Jun23&notFound=true):


Accountants calculate values for things whose values are unmeasurable all the time. They have no trouble assigning value to loans that might not be collected, office buildings whose prices rise and fall with the real estate market and interest rates, and all kinds of contracts whose final value will not be known for years.

Calculating the value of options, in fact, is one of the great accomplishments of modern business mathematicians, Blitzer said. "There is very little in financial modeling that has been tested more than options pricing models. There have been a zillion PhD theses written on it."

Now that I think about it, how does this even stop the abuse? Just because there is an expense on the front end, how does that keep an unethical CEO from inflating the value of the company for a short term gain?

EDIT: funky quotes

I think "lost option sale revenue at time of issuance" is a lot better idea for this very reason.

Oh, and Philo, my last post explains why unexercised options don't have to be treated as revenue as a counterbalance.

[JeffL]

Ah - thanks Jason. I completely forgot that options can be purchased on the open market and thus have a "real" value at the time of issuance, which has nothing really to do with the actual exercised value (which is the "real" value in my mind.) I was purely thinking of employee options given as a benefit and their actual realized value.

Hmmm. Still seems pretty amorphous, and I'm still not convinced it had much to do with the actual criminal dishonesty going on in a few companies.

[TimElhajj]

I see what your saying now. Thanks for explaining that to me. It's funny that I hear so much about options and I've discussed it with people at length, but still get confused. Accepting a job where compensation includes lots of options but a low salary really is a huge gamble--no wonder those unethical CEOs are the only one's who can make it work!

[Jason McCullough]

In an indirect way, options, and especially not expensing options, encourage "irregularities." Not expensing options encourages their use more than if they were properly expensed, and the problem with using options in the first place, instead of other forms of compensation for employees, is that they have a pretty bad case of moral hazard.

http://www.economist.com/business/PrinterFriendly.cfm?Story_ID=1235996


On the evidence so far, who is right? One place to look for the answer is bosses' pay. The theory is that the huge amounts of stock options dished out to executives in the 1990s encouraged them to behave badly. Unlike stock itself, a stock option has no downside: the owner might gain a lot of money if his company's share price rises, but he loses only the cost of the option if the share price falls (and nothing at all if the option is given to him). That might have encouraged excessive risk-taking at the top—a willingness, as Ira Kay of Watson Wyatt, a pay consultancy, puts it, to “roll the dice”.

Combined with the freedom to sell the company's stock once the option is exercised, stock options might also have encouraged short-term business strategies, or even fraud. By fiddling with their accounts, company bosses could hope to drive up the share price, cash in their options, and set sail in their yachts.

I've seen an argument that Congress made some sort of "cap" on direct CEO salary in the 1986 tax law at 1 million by not letting any amounts above that be deductable from taxes, but I can't find anything about it online. Anyone know about this? If that's the case, it should definitely be removed, as that in of itself will drive the use of options instead of salary above 1 million.

[TimElhajj]

I don't have a solution for how to compensate a CEO without encouraging unethical behaviour, but I can tell that there is a downside to options that the author of the economist story leaves out: loss of potential compensation. The deal with most companies that offer huge grants as part of compensation is that you have to endure a low salary. I read somewhere that maybe the solution is just to give actual stock instead of options. I could get behind that. I can't think of a downside for CEOs or mere mortals.

[Mark Asher]

"Hmmm. Still seems pretty amorphous, and I'm still not convinced it had much to do with the actual criminal dishonesty going on in a few companies."

Maybe not, but if handing out excessive options to high level execs makes it harder for the company to look profitable, I'm all for it. These guys come in with the idea of doing whatever it takes to drive up the stock price, and I think they tend to cut corners and, sometimes, abuse employess by cutting jobs to look more profitiable in the short run. Handing out a lot of options should put some downward pressure on the price of the stock.

[DavidCPA]

I've seen an argument that Congress made some sort of "cap" on direct CEO salary in the 1986 tax law at 1 million by not letting any amounts above that be deductable from taxes, but I can't find anything about it online. Anyone know about this? If that's the case, it should definitely be removed, as that in of itself will drive the use of options instead of salary above 1 million.

I believe the $1 million "cap" was passed as part of Clinton's first tax package in 1993. It is a sham because it includes language about no more than $1 million "unless" based on specific goal achievement or some such language. The compensation experts have long left any problems associated with that rule behind. CEOs get plenty of salary and cash bonus before any stock options kick in. The stock options are what drives the salaries into the tens or hundreds of millions of dollars in annual compensation.


1986 tax law

I almost lost my dinner that someone thought that Ronald Reagan and a Republican Senate would approve a piece of tax legislation that actually capped executive compensation.

-DavidCPA

[Jason McCullough]

You're right, it was 1993. I can't remember if it was part of the Clinton tax plan or not. Looks like the capped deductability of golden parachutes back into 1984, though.

http://www.irs.gov/formspubs/display/0,,i1%3D50&genericId%3D10820,00.html

http://www.irs.gov/formspubs/display/0,,i1%3D50&genericId%3D10421,00.html

http://www-rcf.usc.edu/~kjmurphy/kjmpolitics.pdf

Pat Buchanan was in favor of it, though. I keep forgetting exactly how much of a literal (heavy control over business is a common thread) fascist he is.

[DavidCPA]

Jason,

Don't cry for the corporations or executives too much. If you read some 10-Ks, executives are covered under an employement contract with defined seperation benefits. Many times you will see language like:

"he will be entitled to a "gross-up" payment in respect of any excise taxes he might incur."

Translation: The executive will be paid for any excise taxes withheld due to the tax regulations.

This was definately part of the Clinton tax package. You remember the one that passed the Senate due to Al Gore's tiebreaking vote. The tax package that allowed the government to achieve a balanced budget during the Clinton years.

Also, just because a corporation can't deduct a cost for tax purposes doesn't mean they won't pay the cost anyway.

-DavidCPA

[JeffL]

Maybe not, but if handing out excessive options to high level execs makes it harder for the company to look profitable, I'm all for it. These guys come in with the idea of doing whatever it takes to drive up the stock price, and I think they tend to cut corners and, sometimes, abuse employess by cutting jobs to look more profitiable in the short run. Handing out a lot of options should put some downward pressure on the price of the stock.

Yeah, but what I see first hand, working for a large corporation, is that a major portion of the compensation of the very upper level management are bonuses (called "variable compensation") that is directly tied to the stock price. So even if you eliminated the options, they're still financially driven to get the stock price up.

Unfortunately, for public companies, I don't see how you get around this. Ultimately the stock holders are the owners of the companies, and they demand that the stock price rises and dividends flow. The whole system hinges on stock price. If your company's stock price gets too low, relative to the assett value of the company, you're going to be gobbled up by another company and probably at least partially dismembered. If your stock price drops too far, your financial rating gets lowered and the cost of capital (actually the cost of money) gets higher, making it more difficult to grow.

Of course, getting the stock price up isn't the problem - if you do it in a real and sustainable manner. That's a good thing, as it means the company is actually becoming more valuable. Lying and cheating is obviously the problem. Also, stock prices have become so disconnected to the actual value of companies, and not because of lying execs: the market has such an irrational, emotive component that causes stock prices to rise and fall based on "feelings" and events that have nothing to do with the companies in question.

[Ben Sones]

It has been suggested (John McCain was championing this, I believe) that board members not be allowed to hold stock in their company at all, and I think it may not be as crazy as it sounds. The conventional wisdom is that a personal investment in their company aligns board members' interests with the shareholders that they represent. That's obviously not always the case, however, and in some instances (Jason's post above has some good examples) it even creates a conflict of interest in which said board members screw the shareholders to feather their own nests.

[Matthew Gallant]

I don't know any non-crazy ideas to solve the problem. I think when the person takes the job they should have the stock's current price as their "base level" or somesuch, and then they can earn salary based on that. If they go below it, they don't get paid. Penalties for workforce reduction as well.

And if they bankrupt the company they get one punch in the stomach from every person that loses their job and then get catapulted into the ocean. The catapult would be of sufficient power to ensure a minimum airtime of 30 minutes. There would be special computer-controlled guns that would pelt the person with dung while in mid-air.

My other idea is that they're declared a x% owner of the company based on how much stock they own, are not allowed to ever sell that stock, and that they receive the same x% of the actual, uncooked profits as their salary. When they quit, they have to just give that stock away to their replacement. If the company posts a loss, they pay back their salary to the tune of x% of the loss. If they can't, it's catapult time.

[DavidCPA]

I don't know any non-crazy ideas to solve the problem. I think when the person takes the job they should have the stock's current price as their "base level" or somesuch, and then they can earn salary based on that. If they go below it, they don't get paid. Penalties for workforce reduction as well.

And if they bankrupt the company they get one punch in the stomach from every person that loses their job and then get catapulted into the ocean. The catapult would be of sufficient power to ensure a minimum airtime of 30 minutes. There would be special computer-controlled guns that would pelt the person with dung while in mid-air.

My other idea is that they're declared a x% owner of the company based on how much stock they own, are not allowed to ever sell that stock, and that they receive the same x% of the actual, uncooked profits as their salary. When they quit, they have to just give that stock away to their replacement. If the company posts a loss, they pay back their salary to the tune of x% of the loss. If they can't, it's catapult time.

Have you or someone you know been recently laid off? :D Very imaginative employement agreement.

I keep my severance package materials (which I thankfully did not have to accept) close at hand as a reminder to not get to dependant on my current job or company.

-DavidCPA

[Desslock]

>Basically, they're saying options should be listed as expenses. So - how do you value an option?

I'm not sure anyone clearly answered this original question. It's not a simple answer -- there's no perfect way to do so.

Here's the basic premise of the problem: the current reporting of earnings doesn't take into account "in-the-money" exercisable options. In-the-money exercisable options are options to acquire shares for a purchase price per share that's less than the current market price per share (the listed stock price). So the perceived "problem" is that those options could readily be exchanged for shares, and therefore it's inappropriate to list the company's profit per share (return to shareholders), without presuming that these options were exercised for shares. Since there'd be more shares outstanding after the exercise of those options, the actual earnings per share would be less than what's outstanding.

But that "problem" has been ridiculously exaggerated, and there's no clean way to deal with it anyway. It's been exaggerated because the current reporting requirements already require companies to disclose option particulars -- so the information is already publicly available: nothing is being hidden from investors. So essentially the objection is that people are too stupid to do the calculation themselves, and therefore need it presented differently.

But the reason it's not currently presented is because there's no way to perfectly calculate the ultimate "expense" when an option is issued -- key to remember is that the exercise price of options is always the per share when issued (so there's no immediate benefit - and option holders only get any benefit if the price goes up and they exercise their option). It's possible the share price will go down below the exercise price of the options before they are exercised (which has happened a lot lately, obviously), making them valueless. It's also possible the company will issue a lot more shares, making the ultimate dilution to shareholders when the options are eventually exercised for shares less meaningful. Or the company could repurchase shares, making it more exaggerated.

So in order to "expense" options, you essentially have to predict all of these contingencies. The most accepted way for doing so is a very complicated formula called the Black-Scholes model (you can get a sense for it here: http://bradley.bradley.edu/~arr/bsm/pg04.html), but even though its perceived to be the best method of predicting the ultimate the expense, it's inherently inaccurate since you're dealing with contingent events.

It's all a ridiculous red herring, really, since all of the information that can accurately be disclosed is already required to be disclosed. What this is clearly all about is just a discomfort with the fact that senior officers of public companies make a lot of money when their company's stock goes up, which annoys people because: (i) people think it's too much money for anyone to "fairly" make (I guess they should be petitioning professional athletes and actors then); and (ii) more importantly, the fact that the stock went up often isn't related in any significant way to the performance of the executive.

All of the new "corporate accountability" rules are ridiculous, and provide illusory security to the six-packers. What people are overlooking is the fact that all of the current scandals resulted from breaches of the current laws -- the actions that people were pissed off at were already illegal, today. The only legitimate concern should be the enforcement of the existing legislation (and increasing the penalties, if you think as I do that they were inadequate).

Sorry for the long post. Hopefully it was of some help.

Stefan

[Matthew Gallant]

As long as those who are running the company are also deciding how much they get paid for it, then there's going to be problems, right?

[Desslock]

>As long as those who are running the company are also deciding how much they get paid for it

They don't. Compensation of executives of public companies is decided by a compensation committee composed of independent (non-employee) directors. By, for the last 20 years at least, the compensation of senior officers of companies has not been decided by the folks running the company.

[Jason McCullough]

>I'm not sure anyone clearly answered this original question. It's not a simple answer -- there's no perfect way to do so.

But that "problem" has been ridiculously exaggerated, and there's no clean way to deal with it anyway. It's been exaggerated because the current reporting requirements already require companies to disclose option particulars -- so the information is already publicly available: nothing is being hidden from investors. So essentially the objection is that people are too stupid to do the calculation themselves, and therefore need it presented differently.

It's all a ridiculous red herring, really, since all of the information that can accurately be disclosed is already required to be disclosed. What this is clearly all about is just a discomfort with the fact that senior officers of public companies make a lot of money when their company's stock goes up, which annoys people because: (i) people think it's too much money for anyone to "fairly" make (I guess they should be petitioning professional athletes and actors then); and (ii) more importantly, the fact that the stock went up often isn't related in any significant way to the performance of the executive.
Stefan

You're arguing that the *actual* value of the options can't be determined; I agree. However, it doesn't matter; the actual value of the stock itself can't be determined at any point in time, only what people are willing to pay for it. The same applies for with options. The actual net value of MSFT doesn't vary by 3% a day, only the price people will pay for it. Employee option grants are compensation, and compensation should be expensed at the market value of the compensation. I don't see what the difficulty is; do you think if the company was selling the options on the open market, people would refuse to buy them because they couldn't figure out what they're worth? They can't do it perfectly, but they can bet on a future stock price this way just as easily and accurately as they can by shorting the stock.

The "anger about executive pay" is a red herring; only the usual liberal suspects are pissed off about that. Everyone else is angry because companies are inflating current earnings by not properly accounting for the future potential of stock dilution through options.

Take Ebay; this is from a Motley Fool article:


eBay issued 19.55 million options last year -- what does that mean? The way I gauge options is to compare them to the total number of diluted shares outstanding during the year options were issued. So for eBay, we take 19.55 million divided by 280.595 million diluted shares, as of the end of 2001. The result, 0.0697, tells us that eBay's 2001 options represented just shy of 7% of total shares outstanding. That's a huge number. At that rate, eBay could dilute shareholders' interests by 40% in just five years.

Currently, if you want to see how much potential dilution (or future liability if it's done through buybacks; it's the same thing) a stock has outstanding in company-issued options, you need to:

1. Find the DEF-14A proxy statement.
2. Take the number of options given to any given executive, multiply that by the inverse of the percentage of total options for the year that executive received.

They don't even put the total goddamn number anywhere, you need to derive it yourself.

'So essentially the objection is that people are too stupid to do the calculation themselves, and therefore need it presented differently.'

Perhaps they should just sent me a copy of all their invoices every year. I mean, I can calculate everything myself, right?

[Jason McCullough]

Oh, the best summary of the whole thing I've found:

It's apparently too hard to figure out how to properly expense a stock option sale, because its future value can't be determined completely.

Yet it's not too hard to figure out how to properly expense a stock sale, because it's future value can't be determined completely either.

[Desslock]

>You're arguing that the *actual* value of the options can't be determined; I agree. However, it doesn't matter; the actual value of the stock itself can't be determined at any point in time, only what people are willing to pay for it.

I disagree - arguably the best definition of "actual value" is what people are willing to pay. The actual value of the shares at any given time is what people are willing to pay at that time. No, I'm arguing that you don't know the actual value of the expense, because it might not be an expense at all, if the option is never exercised (because the option grantee doesn't have the opportunity, or elects not to, exercise while it's in the money).

>They don't even put the total goddamn number anywhere, you need to derive it yourself

Are you stating that there's no requirement to state the aggregate outstanding options? If so, that's a difference between Canadian and U.S. securities law that I wasn't aware of and, like you said, it's a stupid omission since you can get the aggregate amount looking at the option grant percentages disclosed in the executive compensation chart attached to the annual meeting proxy circular.

[JeffL]

I'm fairly certain that you can see the number of options that a company issues to top executive, and for sure you can see precisely how many options are exercised (as well as stock sold and bought) for the top executives of any company.

Again, Desslock expresses my puzzlement on the valuation of options: many options are never exercised, due to the stock price never hitting the point where they make money (even taking into account that you usually get them at a decent price point.) Thus those options never cost the company any value at all. James, I think your argument is that they are worth the cost of a similar option to the public at the time of issue, but I assume that would be valid only if the company would have offered the same number to the public had they not been issued to employees.

By the way, it's a fallacy to think that options only go to top executives. Many companies, such as the one I work for, offer them at all levels of the company for good performers.

[Jason McCullough]

>You're arguing that the *actual* value of the options can't be determined; I agree. However, it doesn't matter; the actual value of the stock itself can't be determined at any point in time, only what people are willing to pay for it.

I disagree - arguably the best definition of "actual value" is what people are willing to pay. The actual value of the shares at any given time is what people are willing to pay at that time. No, I'm arguing that you don't know the actual value of the expense, because it might not be an expense at all, if the option is never exercised (because the option grantee doesn't have the opportunity, or elects not to, exercise while it's in the money).


That's why I said guessing the future exercise percentage and stock price is pointless: the market for options determines it for you.

If the company prints some new stock, there's a 100% chance that all other shares will be diluted. Options are between a 0% and 100% chance that all other shares will be diluted. What's the *current* cost of the chance the option will be exercised? What you can sell it the option for in the market. Why not put that as an expense (or net worth, whatever it should be stuck under, as long as the value's right?)



>They don't even put the total goddamn number anywhere, you need to derive it yourself

Are you stating that there's no requirement to state the aggregate outstanding options? If so, that's a difference between Canadian and U.S. securities law that I wasn't aware of and, like you said, it's a stupid omission since you can get the aggregate amount looking at the option grant percentages disclosed in the executive compensation chart attached to the annual meeting proxy circular.

I'm not entirely sure; for example, Ebay's proxy lists the total shares outstanding and the weighted average.

http://www.freeedgar.com/EdgarConstruct/Data/891618/02-1977/f79950dedef14a.htm

However, the weighted average is useless: the weighted average of (1,000 @ 10, 1000 @ 20) is the same as that of (1,000 @ 5, 1000 @ 25), yet the amount that would hypothetically be exercised at some future point at 8 is different for the two sets; 0 in the first set, 1,000 in the second set. Basically, you have to work through the proxies for the last n years and try to assemble a data set of what the options were all issued at.

Why are they doing this, instead of the much-clearer market-value expense method? In my opinion, the companies must think they're getting something by not clearly stating the outstanding value of their options. The harder information is to get, the more likely something will be mispriced because of it, and in general they can keep their stock price higher than it would be otherwise by not being above-board about the future dilution potential. And in whose interests does it work if the stock price is higher than normal? Why, the people with the options, of course.

Using fair-market value expensing at issue time also clears up how to value repricing; just treat it as a new issuance.

Another annoying side effect of options not needing to be expensed is that you can completely eliminate the tax liability of any company by just issuing enough options to cover up your profits. Check out this story:

http://www.fool.com/portfolios/rulemaker/2000/rulemaker000217.htm

It all adds up to serious distortions in the balance sheet, when the entire point of the balance sheet is to provide a clear picture of how the company's doing.

[Jason McCullough]

Jason, I think your argument is that they are worth the cost of a similar option to the public at the time of issue, but I assume that would be valid only if the company would have offered the same number to the public had they not been issued to employees.

How does that change the cost to shareholders in dilution though the option?

[JeffL]

"How does that change the cost to shareholders in dilution though the option?"

OK - I'll reveal my ignorance here. When I exercise my options, through my local broker (which is how I do it), am I not acquiring stock from the current pool of company stock, albeit at a subsidized rate? Or are new shares generated just for me?

[Desslock]

>If the company prints some new stock, there's a 100% chance that all other shares will be diluted. Options are between a 0% and 100% chance that all other shares will be diluted. What's the *current* cost of the chance the option will be exercised? What you can sell it the option for in the market. Why not put that as an expense.

That's a good summary. The reason I'd argue against putting as an expense is because it's a contingent expense, and quantifying it at all is misleading since your estimate is likely wrong, and perhaps materially wrong. Why force companies to play that sort of guessing game, and require the introduction of numbers that we know are going to be inaccurate, and potentially misleading?

But there should be full disclosure of: (i) the number of shares that can be acquired pursuant to outstanding options, and the number that are currently 'in the money', and (ii) the particulars of all option grants to the top 5 executives, as well as the number of shares the executive group can acquire pursuant to options. That way, to the extent investors want to see how much the earnings/loss per share are potentially diluted by options that may one day be exercised.

But introducing expense approximations is a mistake, in my opinion, because it's inherently inaccurate and will just create additional opportunity for companies to report their results in inconsistent ways.

>Another annoying side effect of options not needing to be expensed is that you can completely eliminate the tax liability of any company by just issuing enough options to cover up your profits

That's true, but due to the inconsistent treatment of options by the tax legislation and GAAP. I completely agree that should be resolved (either way).

Stefan

[Desslock]

>OK - I'll reveal my ignorance here. When I exercise my options, through my local broker (which is how I do it), am I not acquiring stock from the current pool of company stock, albeit at a subsidized rate? Or are new shares generated just for me?

New shares are generated for you, although the maximum number that can be issued pursuant to option grants is approved in advance (by the shareholders, if the number is changed after the company is a public company, and the listing exchange(s)).

But companies are not required to reflect that option pool of stock when expressing their earnings/loss per share (because the shares aren't actually issued yet, they are just reserved for issuance), which is the perceived problem -- if you include those options, there are actually more securities outstanding, and therefore the earnings per share are less, because the earnings should be divided by a larger ownership pool.

Stefan

[Jason McCullough]

>If the company prints some new stock, there's a 100% chance that all other shares will be diluted. Options are between a 0% and 100% chance that all other shares will be diluted. What's the *current* cost of the chance the option will be exercised? What you can sell it the option for in the market. Why not put that as an expense.

That's a good summary. The reason I'd argue against putting as an expense is because it's a contingent expense, and quantifying it at all is misleading since your estimate is likely wrong, and perhaps materially wrong. Why force companies to play that sort of guessing game, and require the introduction of numbers that we know are going to be inaccurate, and potentially misleading?

But there should be full disclosure of: (i) the number of shares that can be acquired pursuant to outstanding options, and the number that are currently 'in the money', and (ii) the particulars of all option grants to the top 5 executives, as well as the number of shares the executive group can acquire pursuant to options. That way, to the extent investors want to see how much the earnings/loss per share are potentially diluted by options that may one day be exercised.

But introducing expense approximations is a mistake, in my opinion, because it's inherently inaccurate and will just create additional opportunity for companies to report their results in inconsistent ways.

>Another annoying side effect of options not needing to be expensed is that you can completely eliminate the tax liability of any company by just issuing enough options to cover up your profits

That's true, but due to the inconsistent treatment of options by the tax legislation and GAAP. I completely agree that should be resolved (either way).

Stefan

I can see the "inaccurate estimating" objection; I disagree (companies guess on depreciation expenses and pensions, too), but that makes sense. What I don't get is that everyone who opposes expensing (that you see arguing in public, at least) says the current situation is *just fine*; why, you can look at the footnote and calculate it all yourself!

Requiring a list of all the options granted at, say, 1% intervals in the current price would be ok, but I'd really prefer the (highly accurate according to Warren Buffett) estimated expense at time of issue.

The tax thing is way slimy; it effectively makes the employees pay more on their compensation than the company would have if they'd kept it. Bleagh.

[Enkidu]

I certainly didn't expect to see a thread on option valuation here. I secretly suspect that Desslock is trying to sell an interest rate collar to Jason. Either that, or Jason wants to get reimbursed for Qt3 reading and internet connection charges as a business expense. :)