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November 2004 Toting Up Stock Options
by Frederick Rose Public companies have been criticized for granting stock options to employees without adding chits to the corporate expense pile. As regulators and some shareholders argue for new rules, Business School researchers try to follow the money—and the logic.It has been a wild ride, these years of employee stock options. Fortunes have
been granted to some option recipients, while others have seen dreams dashed, as
failed employers’ options took on the charm of losing lottery tickets. Many economists, accountants, and investors have for years argued that successful options dilute shareholders’ future returns, that they have value inherent in any other option, and that they therefore must be considered in corporate expenses. Über-investor Warren Buffett, CEO of Berkshire Hathaway, asked pointedly a decade ago: “If stock options aren’t a form of compensation, what are they? And if compensation isn’t an expense, then what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?” Accounting for employee stock options thus has been a riddle. After some 30 years of dispute and countervailing pressures, options are once again the focus of accounting debate. Companies currently must follow a Financial Accounting Standards Board ruling cobbled together in 1995, when the last major battle over options accounting was fought. Forces that favored compulsory expensing lost that earlier policy debate. The current rule, known as FAS 123, came into effect for fiscal years ending after December 15, 1995, and began to lift the veil around options. But, while FAS 123 requires employers to disclose some calculations for employee options grants in financial notes, there is no stipulation that costs be expensed on the corporate income statement. The FASB and its supporters were routed at the last minute and compelled to permit a giant loophole. The loophole frees employers to avoid income statement recognition of options expenses by opting for the 1972 Opinion 25 that had allowed avoidance of options expensing in the first place. FAS 123 added the requirement for footnote disclosures. Now, the Financial Accounting Standards Board is again moving toward requiring options expenses. “Let the mud-slinging begin—again,” CFO Magazine sniped earlier this yearAnd indeed it did. Global pressure played a hand this time. The International Accounting Standards Board—Business School professor and associate dean Mary Barth is a member—has adopted requirements much like those of FAS 123, but stipulating that the calculations be used to determine income statement expenses. The international standards will come into force January 1, at which time American accounting standards could be weaker than elsewhere if solutions aren’t set in the United States. But on this round of debate there has been new insight. In a potential breakthrough, two Stanford professors created a key to the accounting quandary. An approach proposed by economists Jeremy Bulow and John Shoven identifies a feature common to virtually all current employee option programs and uses that to overcome many of the problems of uncertainty that blocked options expensing in the past. Accounting and securities regulators expressed considerable interest in Bulow and Shoven’s proposal, and earlier this year a Financial Times opinion piece endorsed the approach. Importantly, the Financial Times piece was written by a triumvirate of options experts that included Robert Merton, who with Myron Scholes was awarded the 1997 Nobel Memorial Prize in Economic Sciencesfor groundbreaking options valuation analysis developed with the late Fischer Black that has emerged as the “Black-Scholes” formula. Bulow, who is the Richard A. Stepp Professor of Economics at the Business School, and Shoven, the Charles R. Schwab Professor of Economics and director of the Stanford Institute for Economic Policy Research, opened up this accounting approach by chopping up the continuous time of an option’s run into discrete units. We’ll consider the theory in more detail, but it is important to first look at present accounting problems with options. Accounting Dissected Barth, Kasznik, and Aboody used footnote disclosures required by FAS 123 to consider assumptions used by the reporting companies. These notes require an estimated value of options grants using the Black-Scholes formula. The calculation appraises the time value of options through an assumed risk-free interest rate, projected volatility of the stock, and forecast dividend yield. There is thus considerable guessing about future periods as much as a decade ahead. If investors believed that options stimulated employees to substantially improve performance—rather than just dipping into the shareholders’ cookie jar—companies with substantial employee options outstanding should perform better, not worse. Yet the Stanford researchers found that the market performance of those stocks with higher estimated options expenses lagged stocks with less. In short, whether the numbers are right or wrong, investors have their opinions, do react, and often don’t like what they see. GSB researchers moreover unearthed distressing signs that investor faith in FAS 123 footnotes could be misplaced. A separate work by Barth, Kasznik, and Aboody finds that wide management discretion over assumptions used in calculations has at times understated publicly reported options expenses. Analyzing over 3,800 corporate financial results during the years 1996 to 2001, the researchers concluded that understatement of these expenses was more likely in cases where companies granted large quantities of employee options and were active in capital markets, thus exposing themselves to more scrutiny by banks and investors. Manipulation of key numbers is easy. While Barth, Kasznik, and Aboody noted little fudging of interest rate assumptions, which can be compared with other forecasts, they found that company estimates of future stock volatility, dividend yield assumptions, and expected option life were subject to “downward management” by firms anxious to keep perceived option costs low and implicit earnings high. Moreover, research by Kasznik and Aboody several years ago found that company managers tend to stick a thumb on the scales when it comes time to set stock option exercise prices—either releasing bad news shortly before options were usually granted or holding off good news until options were set. In either case, exercise prices would be depressed—to the prospective advantage of management option recipients. Timeline Solutions To implement this method, firms would expense the value of 90-day options at the beginning of each quarter, the value determined by the exercise price and the current stock price. This expense would be offset partially by the ending (intrinsic) value of any 90-day options expensed in the previous quarter and not exercised. Firms would have some flexibility in choosing when to begin expensing unvested options, but they would be taking the risk of a large charge if the stock price rose before expensing began because there is no offset in the first quarter that an option is expensed. This approach prompted keen interest. “The Bulow-Shoven method appears to remove one of the last valid arguments against expensing options. In the coming months, all sides of this debate will have to reconsider their views and positions,” wrote Financial Engineering News in a recent article. But the Bulow-Shoven proposal arrived late on the scene and conflicted in some important parts with standards the FASB had put forth in draft policy earlier this year. It also differed from the International Accounting Standard that is to come into effect on January 1 after extensive efforts to coordinate with U.S. standards. While the economists found substantial initial interest among regulators, the FASB in early August voted to stick with its earlier proposed revisions. Minutes of the board’s meeting indicate the board—contending in part that elements of the approach were at odds with current accounting concepts—sidestepped the economists’ proposals. Bulow is sympathetic with the FASB’s position. “It’s very tough for these regulators,” he notes. “Accounting rules pre-date modern financial theory, and the regulators must develop each rule with an eye toward how it affects everything else.” He likens the problem to computer coding complexity. Microsoft’s current Windows software is far bulkier and more convoluted than modern Linux coding “in part because it must be made backward compatible to previous systems, which in themselves were developed to be backward compatible all the way back to DOS.” Even so, once opened up, the economic interpretation of options accounting may yet give rise either to restructured employee incentives or eventually to yet another accounting change, he suggests. “For a variety of reasons, most people not in the business of charging for option valuation software or suing companies would be better off if we adopted some version of Bulow-Shoven,” he says. All of this is evolving in part because the political landscape has changed since the mid-1990s, when major corporations in traditional industries joined newer-wave technology firms to oppose options expensing. The embarrassment of managerial and corporate overindulgence revealed in the market crash of 2001 and 2002 changed the tenor. Many heavyweight players have since abandoned the battle. Coca-Cola and General Electric already have elected to expense options under FAS 123. Opposition lingers in the technology sector, where employee stock options have been a way of life that is hard to leave behind. History is on the reformers’ side. Accounting standards have been through similar clashes in the past, as when the more accurate “successful efforts” accounting for oil exploration and production collided in the late 1970s and early 1980s with the flakey concept of “full cost accounting,” which was widely used by small oil companies in a style so slack that cynics called it “no cost accounting.” Despite forecasts of financial cataclysm, stiffer regulations were imposed to the ultimate benefit of investors and the institutions themselves. |
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Wrestling with Stock Option Valuationby Frederick Rose In their worlds of equations, economists rarely take up thorny questions of corporate accounting. Occasionally, however, they may bump into bean-counting questions when they go weightlifting with a pal, as GSB Professor Jeremy Bulow discovered. Bulow and economist David Yoffie, a Harvard Business School professor visiting Stanford, jointly hired a student to coach them on weight training a while back. After working out with the barbells, Bulow and Yoffie, who is a director of Intel Corp., used to head to the Arrillaga Alumni Center Café for lunch and gossip. Bent over the table one day, “we were talking about employee options and it came out that Intel had this feature which I hadn’t been aware of, that if you leave the firm you only get 90 days to exercise the options, regardless of the reasons for departure,” Bulow recalls. “It wasn’t that anybody was keeping the 90-day feature of options secret,” says Bulow, but that mere scrap of information prompted the Stanford economist to consider one of the weighty matters of the accounting world. Unencumbered by years of accounting precedents, “it was a very small leap [from knowing of the 90-day limit] to figuring out how to deal with vested options,” Bulow says. “Really, it took just a moment.” But some important questions remained: Was this 90-day feature truly a widespread practice? What were the mathematical and accounting features of this element? Hardest of all, how should non-vested options be handled? “I went to my friend John Shoven’s office, having thought about who would be the best person to work with on this at Stanford—and the most fun,” Bulow recalls during a joint interview in Shoven’s airy, sun-lit office. Calls went out to Silicon Valley compensation experts, who confirmed that a 90-day accelerated expiry on leaving a firm was an almost universal feature of options. What to accountants had perhaps seemed a trivial fillip in the process jumped up at the economists. “Until we started looking at this, I thought the word ‘vested’ meant the same thing in options that it does in pensions—where if it’s vested it means it’s yours come hell or high water,” says Shoven. Not so. It took almost a year of theorizing, research, and writing to hammer out their approach. Bulow and Shoven, who have worked together and been friends since they met as undergraduate (Bulow) and graduate student (Shoven) working for economist James Tobin at Yale, brought an entirely different background to the options issue. Both men had done research on economic issues of pension plans, which share some features with options. Moreover, Bulow’s doctoral thesis had in part proposed a somewhat similar approach to valuing employee pension expenses. “We are not among the several hundred top options pricing experts in the world,” Bulow adds with a chuckle. But “it turns out that to do something like this, the set of talents that were really helpful included knowing a little bit about options—just enough so that you sort of understood what they were doing. We did, but we had to throw off some of the rust. We had some false starts. Add to this a little knowledge about labor economics, and a little bit about game theory. “There might be people who were way ahead of us in terms of the option pricing part, but on the margin, we just had enough. And the fact that they were more sophisticated than us just didn’t matter so much, as we knew a little bit about all the other things.” RESEARCH PAPERS CITED Accounting for Stock Options
SFAS 123 Stock-Based Compensation Expense and Equity Market Values Firms’ Voluntary Recognition of Stock-Based Compensation Do Firms Understate Stock-Based Compensation Expense Disclosed under SFAS
123?
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