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Stock Option Accounting Shuffle

Many compensation experts, including those with financial-management pedigrees, believe it is impossible to assign an accurate value to a stock option.

September 18, 2003
Related Topics: Finance/Taxes, Compensation Design and Communication, Benefits
If executive compensation and corporate accounting scandals are lightningrods for criticism of corporate America, then stock options are the keysdangling from their kites. As accounting-rule-making organizations debatedwhether companies should treat stock options as an expense, more than 100corporations, including Coca-Cola, Amazon, Dow Chemical, Merrill Lynch, andWal-Mart, began expensing stock options-typically a hefty portion of executivecompensation in most large public companies-for the first time in 2002.

    In most cases, the additional expenses reduce profits. To what extent dependson how many stock options the company issues. Technology and start-up companiestend to rely much more heavily on stock options as a compensation instrument.Amazon’s switch to expensing stock options would have reduced its earnings pershare in fiscal year 2001 by about 69 percent, whereas Wal-Mart’s switch wouldhave lowered its earnings per share in fiscal year 2001 by 1.3 percent,according to Wall Street Journal calculations.

    The International Accounting Standards Board is collecting comments throughMarch 7 in response to its November proposal that companies should treat stockoptions as an expense. That should interest executives at United States-basedcompanies because their accounting rules organization, the Financial AccountingStandards Board (FASB), is working closely with the IASB to develop a single setof globally accepted accounting rules. It also raises some eyebrows, since stockoptions are a much less common form of compensation in the United Kingdom andEurope than they are in the United States.

    In 1995 the FASB tried and failed to require companies to account for stockoptions as an expense. Financial Accounting Standard (FAS) 123-which to this daydefines how companies should account for stock options, whether they expensethem or not-came out of that effort. Last August, the FASB proposed new rulesfor companies that voluntarily expense options. That proposal, which has yet tobe approved, governs how companies that make the switch would restate pastfinancial statements. Adding to the confusion is the high-level turnover at theSEC, the implementation of the far-reaching new Sarbanes-Oxley Act (whichprohibits loans to executives and directors, and contains a wealth of otherfinancial reporting and governance mandates), and strong opposition to rulesthat would require the expensing of stock options.

    Intel chairman Andy Grove argues that option grants already are accounted foras earnings dilution in each earnings report. Grove also advocates betterdisclosure to shareholders of that dilution and of the distribution of stockoption awards among executives and rank-and-file employees. He’s not alone.Many compensation experts, including those with financial-management pedigrees,believe it is impossible to assign an accurate value to a stock option. CharlieTharp, professor of human resources management at Rutgers University and aformer HR executive with Bristol-Myers Squibb, voices a commonly held concernthat expensing stock options might limit their use with the non-executives whobenefit from this kind of reward.

    "The question is, if we do expense stock options using whatevermethodology, will that lead to better decisions around investments and betterdecisions around pay?" Tharp asks. "For all the imperfections that exist inthe methodologies, I’m not sure that it necessarily gets you the betterdecisions, which should in fact be the whole purpose of doing something likethat.

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