The highly controversial practice of expensing stock options comes up frequently when we are training managers. Understanding options and how they impact financial statements is part of becoming financially intelligent.
Some believe that expensing stock options helps to more truly represent a company’s financial standing; thus it’s appropriate. Others believe that expensing options hinders the ability of small growth companies to succeed.
Recently Joe attended a national conference where a keynote speaker, a former CEO of one of the most successful retail chains, said that had he been forced to expense options during the growing years of the business, the company would never have succeeded. First, because they would have used fewer options to recruit, thus limiting the talent they could attract. Second, they would have taken much longer to get to profitability because of the added expense of options. The law changed in 2006, and people are still debating it. So go accounting controversies! Here is a primer on the subject.
Stock options are often used as a way to entice employees to join a small start-up company at lower than market salaries. Often, these employees are betting that the stock options will be worth millions when the company’s shares grow above the option’s strike price, or its price when the option was issued.
The strike price of an option is usually issued to new employees at or above the fair market value of the stock on the date of issue. For example, the strike price may be $3.00 a share, but at the time of issue the company’s stock is trading at $2.50 a share. That is when the option is considered underwater there is no taxable gain to the employee who is issued this option.
Until 2006, these options were simply reported in the notes section of the financial statements in accordance with the Generally Accepted Accounting Principles (GAAP), but did not impact the financial statements themselves. In 2006 FAS 123 of the GAAP code was modified to require companies to show options as an expense on the income statement. This means that the costs of these options would be shown as employee compensation along with salaries and other expenses. The controversy began.
The argument for expensing options was simple. First, investors like Warren Buffet argued for years that many companies enticed executives and managers with lower-than-market salaries because they also offered options. This inflated the companies’ profits because of the lower salaries — hence lower expenses on the income statement.
In addition, if the company did well and the stock options appreciated, then the shares outstanding were diluted by these options that were now “in the money.”
The other side of the argument is based on the fact that it is very difficult to value options that are under water at the time of issue. Many accounting purists would say that there is no tangible value at the time of issue because the option is priced at or below the current market price.
There was a corporate uproar when GAAP changed. Congress was lobbied to reverse the decision of the Financial Accounting Standards Board (FASB). It is quite rare for Congress to get involved in accounting policy and in the end the changes stood and companies now expense options.
We like to say that accounting is primarily adding and subtracting, and when it gets complicated, we multiply and divide. Now, with the expensing of options, differential calculus became part of the equation. The value of an option involves the volatility of a stock, its current price, terms of the option, and its vesting period. The two most frequently used models to value options are the Black-Scholes and the binomial models.
So how have companies handled the accounting change? Some have stopped using options or limited their use. Others provide pro-forma statements for investors that show profit before the expensing of options.
We believe that the market has adjusted to this new accounting rule and it has not adversely impacted small growing companies. Furthermore, it does give a more accurate picture of a company’s expenses.
Originally published on Harvard Business Review Blog.