Robert
E. Jensen, Ph.D.; CPA
Jesse H. Jones
Distinguished Professor of Business
715 Stadium Drive
San Antonio, TX
78212-7200
Phone: 210-999-7347 Fax:
210-999-8134
Email: rjensen@trinity.edu
Web Site: http://www.trinity.edu/rjensen
This document commenced as a letter to Senator Schumer in reply to a letter to the Senator by Walter Schuetze. Over time it has become a log of threads of my own thinking and messages from my friends.
On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed Statement, Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that such transactions be accounted for using a fair-value-based method.
The Board invites comments on all matters in the proposed Statement, particularly on the specific issues discussed in the Notice for Recipients section. Respondents need not comment on all of the issues presented and are encouraged to comment on additional issues as well.
Continued at http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml
"Expensing
Options: An Overblown Storm," by David Henry, Business Week,
FASB, the accounting rulemaking body, has heard plenty from opponents of its
new proposal. Their chances of prevailing are slim, however.
NO REPEATS.
Representative Richard H. Baker (R-La.) announced just hours after FASB posted
its draft on Mar. 31 that he will hold hearings on its impact before his
capital-markets subcommittee of the House Committee on Financial Services. He
says the rule could stifle new companies and job creation. "I fear FASB is
beginning to stand for Flatten All Startup Businesses," he said.
Still, this time around observers doubt FASB will buckle again -- or have to. Current board members generally view the 1994 episode as a debacle that must not repeat itself. It damaged FASB's credibility as a principled rulemaker and weakened the board's resolve to back rules that corporate executives might not like, even if they would help investors.
In the interim, many experts
agree, executives have become even more aggressive in their ploys to use
accounting rules to pump up earnings to drive up stock prices -- and their
options payoffs. FASB Chairman Robert Herz has been stoically saying for months
that part of his job this spring will be going to
LITTLE IMPACT. Besides will power, FASB has momentum on its side. Not only have nearly 500 companies volunteered to begin expensing options but they've generally seen no bad consequences from doing so. A study of 335 of those companies by Towers Perrin, a compensation consultant, found no impact on their stock prices.
The proposed rule would likely reduce reported earnings of S&P 500 companies by less than 3%, according to analysts at Bear, Stearns & Co. That's down sharply from the 18% hit they would have been felt had the rule been in effect in 2002. The reason for the decline: Other earnings have increased, and companies have been issuing fewer options and apparently shifting to other forms of pay.
At the same time, despite the
efforts of U.S.-based tech-industry lobbyists, the International Accounting
Standards Board recently adopted a similar expensing rule that will apply next
year to more than 7,000 companies listed in
Continued in the article
At long last, the IASB decrees that employee stock options must be booked!
Message
from SmartPros on
Feb. 20, 2004 (San Jose Mercury News) — International accounting rule-makers decreed Thursday that companies must begin to deduct the cost of stock options from corporate profits starting in 2005, dealing a blow to the U.S. technology industry that had been hoping global political pressure would derail the rule.
The long-anticipated rule by the International Accounting Standards Board will affect an estimated 7,000 publicly traded companies in 90 counties, but not the United States.
But the IASB's counterpart in the United States, the Financial Accounting Standards Board, plans to issue a similar proposal in March. And the two accounting groups have been working closely together to make the two rules as symmetrical as possible.
"It doesn't change much in
terms of what's happening in the
The London-based IASB developed the global standard because a mish-mash of national rules generally do not require companies to account for options on their financial statements. That has resulted in understated expenses and inflated profits, IASB Chairman David Tweedie said in a release.
The rule, Tweedie added, "will improve the qualify of financial reporting by giving a clearer and more complete picture of an entity's activities, which will assist investors and other users of financial statements to make informed economic decisions."
The
"A lot can happen between crouch and leap," Stern said. But, he added, "I think most people think mandatory option expensing is inevitable."
As the FASB and SEC struggle to join the International Accounting Standards Board (IASB) in requiring the expensing of stock options when vested (which I think is the best accounting alternative), the large and powerful technology industry lobby is swinging its weight around the halls of Congress to get its own way.
"Expensing
of Stock Options Isn't the Answer, Readers Say," The Wall Street
Journal,
Lee Gomes said in Monday's column that tech executives opposed to stock-option expensing would get an F from their old business school professors. While I still believe as much, I must concede they would get A's from their college writing teachers, as I received a number of vigorously-argued critiques of the accounting rule change I was supporting. Many readers agreed with the column, but since I compared opponents of stock option expensing to Chicken Little, it's only fair to turn this forum over to them.
Craig R.
Barrett
Chief Executive Officer
Intel Corp.
In today's article you go to great pains
to point out that we should have accurate reporting (honest accounting) of
earnings and use this as a main thesis in defending the expensing of stock
options. You (and others) are quick to point out that options are an expense
and should be counted as such. The only problem is that after many, many years
of trying, FASB and others have been unable to come up with anything that
approximates an accurate expensing method. Just go and see how accurate the
expensing that Coke used for their options tuned out to be in retrospect. Or
how about the billions of dollars of expense that companies like Cisco Systems Inc. and Intel Corp. would have to take
for options that might never be exercised?
You quickly bypass this trivial issue with the tired excuse that the rest of our accounting methodology is inaccurate, so why worry? If our accounting is so inaccurate, why not urge FASB to get back to the real basics of the problem (cash accounting)? What about Sarbanes-Oxley, supporting inaccurate reporting of corporate results as just the natural result of poor guidelines from FASB.
As a CEO I find this trivialization of accounting almost as insulting as your insinuation that the supporters of stock options "would have earned F's from their old business school professors." I would like your side in this argument to address these issues:
• FASB's
proposed accounting for options is just plain inaccurate, and everyone knows
it. Why will a single, inaccurate number be better than the several pages of
detailed option data we currently provide, if our goal is to provide clear and
transparent accounting to shareholders?
• Why isn't the current dilution of earnings per share
the best possible information to be provided to shareholders? After all,
shareholders will approve all option programs and options are really just a
dilution of ownership.
• Many accountants feel that options are not a true
expense, despite FASB's view. Why is this not considered?
• And yes, we do raise the jobs issue as part of the
debate. The Chinese Communists are promoting the use of options, and not for
competitors of Coke or other companies who expense options but whose options
are typically given to only the top few employees, but for high tech companies
like Intel and Cisco. You can ignore this aspect if you choose, but I doubt
those who do have run a company in high tech and competed with the rest of the
world.
• My predictions if expensing wins:
• Companies will return to pro forma accounting to
give an accurate representation of their financials -- this will marginalize
FASB.
• Trial lawyers will have a field day with the
inaccurate methods used to account for option expensing -- how can they
possibly ignore the billions of dollars of inaccurate expenses taken when stock
prices don't follow expected trends? CEOs knew or should have known that their
choice of option expensing algorithms were inaccurate.
•
Your argument ignores these details. We may yet lose the battle on expensing, but trivializing our motives really misses the point.
Frank Huerta
San Carlos, Calif.
I think that
incentive options help fuel
I am one of those students that took options and futures in business school at Stanford and have actually gone through the mechanics of pricing options via the Black-Scholes and binomial models (two of the methods being proposed to value options). The key components in these models are the stock price, strike price, interest rates, time to expiration, dividend, and volatility. Of these, the volatility is the one unknown and requires approximation (typically the computer models use a log-normal distribution of stock prices of PAST performance for this predictor of future volatility, a reasonable estimator that may not always be accurate).
This volatility estimator creates one problem. The option pricing models generates a number that may be used for accounting purposes, but is that the right price? Rather, is it a market clearing price? Options are traded every day for public companies for a price based on supply and demand and the other factors mentioned above. The market determines the volatility by looking at the past, but also the future of the business and its environment and that adjusts the price. The volatility that is derived from the price of exchange traded options is known as the "implied volatility." So, really, the market "creates" the volatility, not the model.
Now for public company options, it might make sense to expense the price of the employee options based on the market price of the exchange-traded options. But this assumes that the employee options match the exchange-traded options in type (American or European), strike price and time to expiration, but that is rare since most employee options are long term (expiration dates of 10 years) and exchange-traded options are usually less than one year, although LEAPS go out a few years typically. So do the pricing methods proposed represent the "true" value of the options in the absence of a market clearing price? Likely not.
In addition to the volatility question, the restrictions imposed on corporate employee option holding and trading impact the "true" value of these options as defined by Black-Scholes or the binomial method. Issues such as: 1) vesting period or "cliffs" (an employee has to hold the option for a set amount of time before he/she can exercise it); 2) trading windows or only certain times or in which the options can be exercised; 3) employee options can be exercised only if they are in the money; and perhaps most importantly 4) the inability to trade the employee option in a market, all create a deviation from the conventional pricing methods for options.
An option has value right up until it expires. Thus, the day the employee is given an option (usually at the money), it has value. This is the value that should be expensed by the company in the period it is incurred. But what is the value? Black-Scholes and binomial pricing do not account for a "lock up" period, and the employee cannot take advantage of that value because he must wait the period of the cliff (say a year), wait for a trading window to open outside of a quiet period, and hope that the option is in the money. Nor can he/she sell the option along the way to capture its value. Even if the employee option is underwater after the cliff, it still has value according to the option pricing models, but the option holder cannot take advantage of this and thus the market is not efficient -- a stipulation of the models.
A good
discussion of this topic is on this Web site.
The point is
that if companies are going to expense the value of employee options, then they
need a better method than what has been proposed to assign and capture the
"true" value of those instruments. Otherwise, the numbers will be
wrong, and I don't want a new item mucking up income statements and balance
sheets any more than they already are.
An interesting idea would be to allow a market to develop for employee options (you may need more supply but I'm sure investment banks could make more money). Then the "true" price can be determined for that derivative instrument and that value can be expensed in or close to the period it is incurred. Companies may have problems with aligning employees with long term incentives since you may have people that receive an option on the first day of employment and then sell them into the market for the money, but there are ways around this.
I'm glad you didn't let the facts get in the way of a good story -- it's more entertaining that way. Given its inclusion in The Wall Street Journal, however, I would have expected your editorial to more than just occasionally delve into reality. As it is, your column on stock options expensing is sensational and misguided (at best).
You begin by telling high-tech executives not to worry about expensing options because Coke did it and "Not only has the sky not fallen, not much else bad has happened." What in the world does Coke have to do with the high-tech industry? Coke and the soft drink industry, which have been around for a combined one billion years, are nothing like high-tech companies and the high-tech industry. Neither is Coke's use of stock options, which in 2002 Coke expected would equate to about one cent per share.
You go on to
say that "
Although the "point" doesn't appear to have been made, why don't I take a crack at the "counter-point," anyway? Expensing options doesn't make a whole lot of sense. Where is the expense? An option merely gives its holder the right to purchase the company's stock at specific price during a certain period of time. How does that at all change the fundamental financial position of the company? It doesn't. The company has not expended a thing. It has only given someone the ability to buy some of its stock that it has set aside for that purpose.
If a holder does eventually exercise, has the fundamental financial position of the company changed then? Yes -- for the better! When holders exercise options, it is a capital-raising event for the company -- the company now has MORE money, not less. There will just be more pieces of the corporate pie. Calling the initial grant of the option an "expense," makes about as much sense as calling the proceeds the company receives from its exercise "income."
The real issue here is disclosure. You stumbled across that reality in the part of your piece where you equate the FASB proposal to the "surgeon general's warning on a pack of cigarettes in bigger type." Compelling stock option disclosure through a strained accounting entry, however, is not the way to go. The FASB proposal tries to force a square peg into a round hole. The focus should be on the potential dilution effect of the stock options' exercise on existing shareholders -- the fact that there will be more pieces of the pie with a potentially less than offsetting increase in the size of that pie. This is the salient discussion, and it cannot be communicated through an accounting entry.
From
The Wall Street Journal Accounting Educators' Review on
TITLE:
Foreign Firms to Expense Options
REPORTER: David Reilly
DATE:
PAGE: A2 LINK: http://online.wsj.com/article/0,,SB107713353964432916,00.html
TOPICS: Financial Accounting, Financial Accounting Standards Board,
International Accounting Standards Board, Stock Options
SUMMARY:
Firms following International Financial Reporting Standards (IFRS) will be
required to expense stock options as of
QUESTIONS:
1.) What factors determine which companies follow International Financial
Reporting Standards (IFRS)? What standards currently govern European companies'
reporting practices?
2.) What are the major differences between current USGAAP and the new IFRS on stock compensation?
3.)
How much will the standard being adopted by the IASB influence development of a
new accounting standard on stock compensation in the
4.)
An analyst with UBS in
Reviewed
By: Judy Beckman, University of
Reviewed By: Benson
Reviewed By: Kimberly Dunn,
---
RELATED ARTICLES ---
TITLE: Major Economies at Loggerheads Over Global Accounting Rules
REPORTER: Andrew Peaple
ISSUE:
LINK: http://online.wsj.com/article/0,,SB107628352527524027,00.html
"Whither the Stock Option? by Ira Kay, Financial Executive, March/April 2004, pp. 46-49 --- http://www.fei.org/mag/articles/3-2004_comp.cfm
While stock options lose more luster as executive motivators, compensation committees face challenges, including selecting other forms of stock incentives.
During the late
1990s, companies issued billions of dollars worth of stock options to motivate
their employees. Those days are likely over, for a variety of reasons,
including potential new rules requiring companies to expense them. But getting
the best out of executives through other forms of stock incentives - including
actual ownership - will no doubt continue, according to a recent study of
executive compensation conducted by Watson Wyatt.
Indeed, stock options' best days may be behind them - not
just because they will soon have to be expensed, but because institutional
investors are increasingly worried about them. Moreover, there is perennial
concern over perceptions of excessive CEO pay and disconnects between pay and
performance. Finally, there is the crisis in governance created by corporate
accounting standards and a gap between the cost and value of options created
when a company's future accounting cost of stock options exceeds their value to
employees.
These factors do not appear to be lessening in importance and
have already resulted in a huge drop in the value of options granted to employees.
From 2001 to 2002, the value of stock option grants at major companies fell by
29 percent, from $139.6 billion to $99.6 billion.
When data for 2003 becomes available, it will likely show a
further decline of 10 percent to 15 percent from 2002. The magnitude of this
drop cannot be overstated: the only other event in the history of executive
compensation as important is the sharp increase in executive pay levels that
took place during the 1990s. However, the recent bull market has softened this
trend, as 2004 values are expected to be up from 2003.
Some analysts believe that the decline in option value was
caused entirely by stock price declines - for example, a company granting one
million stock options at $30 in 2001 and one million at $20 in 2002. Other
things being equal, their value would have declined by 33 percent, solely due
to stock price movement. But this is not what happened. In fact, declines in
both stock price and the number of stock options granted are responsible.
For the average company, the 29 percent total decline in
stock options value cited above came about as a result of a 20 percent decline
in the average number of stock options granted to all employees, from 7.6
million to 6.1 million, and a 16 percent decline in the average value per
option, from $17.25 to $14.50, almost entirely due to stock prices falling.
Options Reflected in Stock
Prices
Consistent with findings in a prior study, investors consider
stock option expenses as real expenses, even if reported only in the footnotes.
As expected for a bear market year, the relationship was negative: those with
the highest option expenses in 2002 had the lowest total returns to
shareholders (stock price appreciation plus dividends). Dividing up the 998
major companies in the recent Watson Wyatt study into three groups, the
companies with the lowest option expenses - those with a 2002 expense of $266
per employee - had total return of negative 4.3 percent. Those in the highest
expense group, with a 2002 expense of $3,997 per employee, had a total return
of negative 12.4 percent.
Pay and Performance Linked
Another important finding is that pay and performance are
strongly linked. Analysis shows a strong, positive relationship between company
performance and executive compensation levels. For example, companies whose
CEOs had higher total pay opportunities from 1998 to 2002, as measured by their
total direct compensation over the five years, had higher total returns to
shareholders during the period than those with CEOs having lower pay
opportunities. The relationship between pay and performance is apparent in
other measures as well:
· Annual increases in a CEO's total cash compensation are positively related to the company's stock performance.
· CEOs of companies that performed below a one-year total return to shareholders median had a decline in actual pay and stock option profits in 2002.
· Companies having CEOs with high stock ownership were superior investments compared to those with low ownership. Companies with high CEO ownership realized a three-year median total return of 3.9 percent for their shareholders for the period ending December 2002, while low CEO ownership companies saw a return of negative 3.4 percent on their investment during the period.
· Investors are willing to pay a premium for companies where senior management and shareholder interests are aligned.
Stock Option Overhang Declining
Stock option overhang has continued to grow - despite efforts
by a large number of firms to reduce their overhang levels between 2001 and
2002 - primarily from a large reduction in the amount of options being
exercised. Stock option overhang is a measure of potential dilution from
granted and approved stock option programs (calculated as options granted and
outstanding, plus shares that remain to be granted, expressed as a percentage
of total shares outstanding). The average stock option overhang increased one-half
percentage point over the average of the same time last year - from 15.6
percent in 2001 to 16.1 percent in 2002 for companies with December 2002
year-ends.
However, there is strong evidence of a decline in the growth
rate of overhang during this same period. Between 1997 and 1999, overhang
levels increased at an annual rate of 11.8 percent, while growth slowed to 7.9
percent between 1999 and 2002. Moreover, the earlier growth occurred as a
result of larger option grants and more extensive programs covering more
employees during a bull market. The current increase can be attributed to fewer
options being exercised as they are increasingly out of the money (worth more
than the current price of the stock), due to declining share prices without an offsetting
decline in new share authorizations.
There are substantial differences in overhang levels by
industry (see Figure 2). Technology and health care firms have consistently
exhibited higher overhang levels than other industries, while utilities have
exhibited the lowest levels of overhang. This is consistent with economic
theory, which predicts that stock-based incentive compensation is more
important in industries with a high share of value derived from intellectual
property.
The study also found that firms with higher overhang levels
have more options outstanding and higher run rates (a measure of shares granted
annually to employees, which are calculated as options granted and expressed as
a percentage of total shares outstanding).
Continued in the article
"Equity Compensation: The Future Is Now," by Blair N. Jones and Jesse Purewal, Financial Executive, March/April 2004 --- http://www.fei.org/mag/Exclusives/3-04.cfm
In lieu of simply replacing stock options with the next 'big thing,' two consultants say companies have an opportunity to strategically rethink their approach to equity compensation.
Although the spate of corporate scandals and accompanying backlash on stock options are seemingly starting to recede, changes resulting from these events are just now taking hold as the Financial Accounting Standards Board (FASB) moves ahead with issuing new rulings on stock option accounting.
A number of high-profile companies as diverse as Microsoft Corp., Kraft Foods Inc., Progressive Casualty Insurance Co. and Amazon.com Inc. have replaced at least some stock option grants with restricted stock. Dilution caused by large stock option grants, the egregious behavior of a few executives who allowed short-term stock price to serve as the hallmark of success and tighter corporate governance requirements for shareholder votes (loss of the broker vote), have made new equity authorizations less of a sure thing.
The implication of these events is that board compensation committees and management teams have had to start with a clean slate when designing long-term incentive strategies. But, therein lies an opportunity: Rather than simply basing changes and adjustments to equity plans on accounting considerations and stock performance, companies now have an chance to strategically rethink their approaches to equity compensation. Which begs the question: Are companies doing so in a thoughtful manner, or simply acting like lemmings by chasing the "next big thing" to replace stock options?
Before answering that question, it
is important to consider the changes companies have already begun making to
their stock option and other equity incentive programs over the last two years.
For the most part, companies have responded to the stock option backlash by
making some changes to stock option programs, but not by eliminating stock
options altogether. According to a September 2003 survey of 336 publicly traded
Fewer stock options for lower levels. Any discussion of changes to stock option accounting invariably raises concerns that reported earnings will suffer even if there is no change in company performance. Associated with this concern is the warning issued by some opponents of stock option expensing that an accounting change will cause companies to reduce or rescind stock option awards to lower-level employees, thereby hurting certain segments of the workforce more than others. So far, that warning is proving to be prescient. Changes to stock option plans are primarily affecting lower-level employees, according to the both the 2002 and 2003 surveys.
Eligibility for stock options decline at lower levels. While eligibility remains largely unchanged for employees at the professional level and above, employees below that level saw eligibility decline. For example, two thirds of sales staff were eligible for stock options in 2002, but only half were eligible in 2003. Eligibility among nonexempt employees fell from 37 percent in 2002 to 27 percent in 2003. Additionally, the survey found that the value of stock option grants over the 18-month period of March 2002 to September 2003 decreased more for non-exempt employees than for any other group.
Restricted stock on the rise. With stock options losing appeal, companies are looking for alternative equity-based incentive vehicles. Enter restricted stock. More companies use or plan to use restricted stock than any other vehicle to replace or supplement stock options. Approximately 60 percent of companies responding to the survey plan to grant restricted stock by September 2004, and more than 40 percent have already established restricted stock as a component of compensation for at least some employees. (See box at the end, "Restricted Stock: Caveat Emptor," for cautions about this trend.)
Performance counts. Companies are taking steps to tie stock option eligibility more strongly to company performance and evidence of value creation. The survey found that 28 percent of companies now use group, unit or company performance to determine stock option eligibility, compared to 17 percent in the earlier survey.
Stock option effectiveness still a question mark.
Despite changes in programs, companies still struggle to achieve their key goals for stock option plans. A majority of respondents report that their plans are only moderately effective at helping to achieve key objectives such as attracting and retaining talent, focusing employee attention on corporate performance and aligning shareholder and employee interests. Even so, equity is still a compelling benefit to most employees. Sibson Consulting Group's 2003 "Rewards of Work" study, which focused on the attitudes of 1,108 workers about the "deal" between employer and employee, found that one fourth of workers who have not received stock options or grants in the prior 12 months would switch employers for just 40 shares of a $10 stock. Workers who had received stock options or grants in the prior 12 months were a little harder to entice but would still change employers in exchange for 100 shares of the same value.
The future of incentives
To avoid the lemming syndrome, companies need to clearly define design
objectives for long-term incentive plans. Few companies can depend on a single
incentive vehicle to address all objectives, and simple tweaks to existing
stock option plans are likely to be insufficient. A complementary plan or plans
that focus on intermediate drivers of shareholder value may be in order.
If a new performance-based plan is to be introduced, financial executives will play a central role in identifying appropriate measures and goals for these plans. Performance measurement is at the heart of good long-term incentive design. Poorly chosen measures, at a minimum, can lead to a sub-optimal plan and, at worst, to significant unintended consequences. Well-chosen measures and goals can enhance organizational focus and lead to superior performance.
Continued in the article
In the table below, I present a series of messages between me and a friend who was trying to make a case for expensing stock options at intrinsic rather than full value (intrinsic plus time value).
|
What if Employees Work for Free? |
|
The following series of message took place between me and a friend, Dr. X, who was trying to make a case for expensing stock options at intrinsic value rather than full value along the lines advocated by Ira Kawaller at http://www.kawaller.com/pdf/AFP_jan04.pdf Initially, I should probably note that FAS 133, IAS 39, CICA 13, and most other accounting standards require booking of both purchased and written options at full value and adjusting this value continuously for changes in both the intrinsic and the time value changes in option value over time. The one major exception is employee stock options that are scoped out of those standards and covered elsewhere such as in FAS 123 that took the frustrating approach that firms may choose between either booking or not booking employee stock options provided current values are disclosed in a footnote. This has made reporting standards for employee stock options highly inconsistent with standards for accounting for all other options such as commodity options held for speculation or hedging purposes. The FASB and the IASB are intending to soon set this straight by requiring that all options be carried at full value (intrinsic plus time value) at all times. In the exchange of messages below, Dr. X tries to make a case for booking only at intrinsic value, which would then make accounting standards for employee stock options still inconsistent with standards for all other options. All these standards on options other than employee stock options conform to effectiveness tests for hedging under Paragraph 63 of FAS 133 that allows effectiveness testing based upon intrinsic, minimum, or full value when booking the full value of options used for hedging purposes. The best place to begin after reading Paragraph 63 is Example 9 in FAS 133 beginning in Paragraph 162. You can also download my 133ex09a.xls Excel workbook from http://www.cs.trinity.edu/~rjensen/ You
can read more about intrinsic value versus full value at http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm Of course, readers of financial statements shouldn’t be blind-sided about this expense — and they needn’t be. An easy to- implement remedy is to record changes in the intrinsic value of these options through earnings throughout the options’ lives. That way, as underlying stock prices appreciate, and exercise becomes a more likely prospect, expenses associated with the options will be transparently displayed. http://www.kawaller.com/pdf/AFP_jan04.pdf The series of messages that took place between me and Dr. X are shown below. In the end, Dr. X phoned me and conceded that he had changed his conclusion in favor of my conclusion that it is far better to make all options accounting standards consistent with the present FAS 133 requirements to carry options at current full value (intrinsic plus time value) at all times. I invite you to show me any flaws in my logic. Jensen Message 1 Hi XXXXX, In return for your help, I have posted a working draft of the differences between FAS 133, IAS 39, and CICA 13 at http://www.trinity.edu/rjensen/caseans/canada.htm You might find this somewhat useful. Please inform me of any errors. With respect to stock options, you argue for booking employee stock options at intrinsic value and not booking time value. This makes accounting for those options inconsistent with the FAS 133 requirement for booking speculations in commodity options (which must be booked at current full value). Are you also advocating modification of FAS 133 for commodity speculation options? And if so, why not argue the same for forward contract speculations? Bob Jensen XXXXX Reply 1 I agree that booking employee stock options at intrinsic value is inconsistent with FAS 133 requirements for booking all other options at full value, but I think the change is worth it. I make a distinction between the value of the option to the employee and the cost to the company. For the former, the full value of the option is clearly what matters, and this value, of course, varies as time progresses and as the option moves in- and out-of-the money. On the other hand, I view the true cost to the company to be the intrinsic value at the point of exercise. Since this option is granted for free, the time value may be of theoretical relevance, but it has no bearing on cost born by the company. Why, then, should the company have to spend all kinds of time and money trying to value something that has no practical import? Forwards are different. If you use a forward, you’re gain or loss will always (as far as I can see) be a function of the changes in forward prices. Ignoring the forward premia or discounts would give wrong answers. Even so, I would like hedge accounting to be changed for options. But that’s another story… Thanks for your responses. XXXXX Jensen Message 2 Hi Again XXXXX, I guess I’m still an old accrual-based bookkeeper. I think the accrual is what we account for irrespective of cash flows. When we book a speculative commodity option on Day 1, there is cash flow for 100% time value equal to the option’s price (premium). There’s generally no intrinsic value on Day 1. In the case of a stock option, there is no cash flow for a premium, but there is a “premium,” in theory, that is equal to the minimum time value on Day 1 that an employee is willing to take in lieu of cash wages. From an accrual standpoint there is little difference between accruing a premium versus paying it in cash. Of course the accrual may never have to be paid in cash, but a lot of accruals booked into the accounts never get paid in cash (e.g., portions of estimated warranties) due to the roll of the dice later on in time. And I don’t see a fundamental difference between forward contracts and options in terms of time value decay. Time value of option and forward contracts both decay to zero on the date of expiration. Payoff is computed in both types of contracts on the basis of intrinsic value. The only difference in theory is that purchased options, unlike written options, have a bounded loss and unlimited gain, whereas speculative forward contracts do not have bounds in either direction. Perhaps this is one of the reasons option values are more volatile and intrinsic value effectiveness tests are more popular with options. However, FAS 133 still requires that time value changes in both option and forward contracts be booked to full value (intrinsic plus time value) such that there is no difference in booking their values under FAS 133. Since one of the major controversies in FAS 133 is how difficult it is to get hedge accounting for the time value of options, perhaps we should advocate that options be accounted for differently (by not booking time value) than other derivatives that require booking of changes in time value. This would be consistent with your argument that employee stock options should not get booked for changes in time value. Most definitely, I do not buy into your acceptance of inconsistent accounting rules for commodity options held as speculations versus employee stock options issued as speculations. My argument is that we either book time value in both instances (which is what the FASB is going to require very soon) or we do not book time value for both types of options. As a compromise that runs counter to conservatism, we might book time value gains but not losses for purchased options since the losses are bounded by the initial premium. Employee stock options are really more like written options than purchased options from the company’s perspective. The employee’s losses are bounded by the initial time value, but the company’s potential losses are unbounded and equal to the unbounded possible gains to the employee. Of course enormous losses from stock options that go deep into the money are offset by the company’s joy that those enormous losses must be accompanied by a soaring price for the company’s shares. So maybe you should advocate that either stock options be accounted for like written options in FAS 133 or that written options in FAS 133 be accounted for like the intrinsic value booking that you advocate for employee stock options but not for commodity options. Judging from your written comments you prefer intrinsic value booking for employee stock options. Why can’t this also be the case for all written options in FAS 133? Bob Jensen XXXXX Reply 2 Whew! One thing at a time... Do you agree with these two points? 1. if company X issues an option and does not receive payment for it, over time the economic gain or loss to the company is equal to – Pend, where Pend is the value of the option at its termination. 2. Pend will be zero if the option goes unexercised or it’s the intrinsic value if the option is exercised. If you agree with those two statements (and I think you must), you should see that time value doesn’t enter into the company’s gain or loss. To say that the company received payment in kind (i.e. labor services) doesn’t cut it. If an employee works without pay, do we record these services? XXXXX Jensen Message 3 Hi Again XXXXX, Actually we do book the value of an employee’s donated services in many instances that would be consistent with booking time value changes in stock options under “b” shown below: Donated Services. FAS No. 116 establishes criteria for recognizing donated services. Services must be recognized as contributions if either of the following criteria is met: the services create or enhance nonfinancial assets (such as volunteers erecting a building), or the services require specialized skills, are provided by individuals possessing those skills, and would typically need to be purchased if not provided by donation. FAS No. 116 lists examples of services requiring specialized skills: accountants, architects, carpenters, doctors, electricians, lawyers, nurses, plumbers, teachers and other professionals and craftsmen. However, employees who are paid in stock options really are not donating free services. They are simply willing to accept the time value of an option in lieu of what they would otherwise demand in a cash wage. Bob Jensen XXXXX Reply 3 When you book those donated services, are they booked as an expense? What are the debits and credits? XXXXX Jensen Message 4 Hi Again XXXXX, Debit Wages Expense and then allocate like we do any wages to such things as Patents, Buildings, Inventory) or a liability if the donation is a forgiveness of debt. Credit Contribution Revenue (or for major asset donations or debt forgiveness, the credit may go to donated capital that is essentially like paid-in capital) In the case of employee stock options that become worthless, the credit should go to Paid-in Capital or something equivalent. In theory, I would prefer crediting revenue for expired employee stock options since this is really equivalent to gambling revenue. The asset such as a building or inventory is then expensed as usual over time or all in one year if the value expires within the year. Most donated services are things like pro bono services of lawyers or doctors. There is a complex problem if the services are in anticipation of future paid services such as when a lawyer provides free legal work or a systems analyst works for free in anticipation of future paid services. FAS 116 requires that the services be entirely pro bono. Volunteer work from non-skilled workers like teenage volunteers on a clean up site are not scoped into FAS 116. Actually, if an employee accepted stock options that have no time value whatsoever, I would argue that this would really be a donated service. Booking the fair value of such services rendered under FAS 116 would lead to better accounting since strange things might happen without booking the value of those “donated” services. For example, widgets costing $1,000 per widget across 51 weeks when the employees are paid $100 per hour may appear to cost only $200 in Week 52 when each employee agreed to accept totally worthless stock options for 40 hours of labor in some religious celebration or catastrophic event. Accepting totally worthless stock options is equivalent to donating services. However, virtually all employees who accept stock options in lieu of a portion of cash wages are not receiving worthless options. These options have time value that is in theory equal to the amount of reduced cash wages. Hence, these options are not donations of service. Interestingly enough, under the present FAS 116 and FAS 123, the fair value of services rendered for worthless options might be booked to into widgets, whereas services rendered for valuable stock options are not booked into the widgets inventory. Inventory becomes understated if something of value is given versus correctly valued of something worthless is given for skilled and valuable donated services. Something is wrong in not booking time value of stock options even if there is a chance that the options will never be exercised. We also book anticipated warranty expenses even though there is a chance that the accrued expenses are overstated. Conservatism in auditing suggests that it is far better to overstate than understate expense accruals. Somehow this got lost in the shuffle when it came to stock options. Bob Jensen XXXXX Reply 4 (by phone conversation) I never views this from the perspective of donated services and had no idea that most donated services were booked as revenue. From this perspective, booking employee stock options at full value rather than intrinsic value makes more sense and is consistent with the standards of accounting for other types of options. I no no longer buy into Ira Kawaller's arguments at http://www.kawaller.com/pdf/AFP_jan04.pdf You can read more about intrinsic value versus full value at http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm The entire mess of accounting for derivative financial instruments is covered at http://www.trinity.edu/rjensen/caseans/000index.htm
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October 31, 2003 Update News
FASB agrees to
propose expensing stock options At its meeting yesterday (October 29, 2003),
the US Financial Accounting Standards Board agreed to expose, for public
comment, a standard that would require companies to expense the fair value of
stock options granted to employees. The proposal would likely be issued in
February 2004 and, if adopted, would take effect in 2005. The IASB published a
similar proposal last year (Exposure Draft ED 2) and is expected to issue a
final standard during the first quarter of 2004, also effective in 2005.
Currently, companies in the
Paul Pacter, IAS Plus,
Bob Jensen's threads on stock option accounting are shown below.
Senator Charles E. Schumer
Dear Senator Schumer:
The disagreement between President Bush and Alan Greenspan
regarding accounting for employee stock options (ESOs) is noted in Appendix C
of this letter.
On
I am writing this response in order to
point out some opposing arguments. My
response is on the Web at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Mr. Schuetze is a friend, and my
arguments below are academic. Nothing
personal in any way is intended.
Since 1964, Walter Schuetze has been an
advocate of exit value (liquidation) accounting in which all marketable assets
are booked at what they would sell for if liquidated at auctions. Because Walter is advocating an accounting
model that has never caught on for going concerns in the
One of the long-time advocates of exit
value accounting was
You can read the following criticism of
proposed exit value accounting at http://www.trinity.edu/rjensen/theory/00overview/theory01.htm
Exit value reporting is not deemed desirable or practical for going concern businesses for a number of reasons that I will not go into in great depth here. Disadvantages of Exit Value (Liquidation, Fair Value) Accounting
1. Operating assets are bought to use rather than sell. For example, as long as no consideration is being given to selling or abandoning a manufacturing plant, recording the fluctuating values of the land and buildings creates a misleading fluctuation in earnings and balance sheet volatility. Who cares if the value of the land went up by $1 million in 1994 and down by $2 million in 1998 if the plant that sits on the land has been in operation for 60 years and no consideration is being given to leaving this plant?
2. Some assets like software, knowledge databases, and Web servers for e-Commerce cost millions of dollars to develop for the benefit of future revenue growth and future expense savings. These assets may have immense value if the entire firm is sold, but they may have no market as unbundled assets. In fact it may be impossible to unbundle such assets from the firm as a whole. Examples include the Enterprise Planning Model SAP system in firms such as Union Carbide. These systems costing millions of dollars have no exit value in the context of exit value accounting even though they are designed to benefit the companies for many years into the future.
3. Exit value accounting records anticipated profits well in advance of transactions. For example, a large home building company with 200 completed houses in inventory would record the profits of these homes long before the company even had any buyers for those homes. Even though exit value accounting is billed as a conservative approach, there are instances where it is far from conservative.
4. The value of a subsystem of items differs from the sum of the value of its parts. Investors may be lulled into thinking that the sum of all subsystem net assets valued at liquidation prices is the value of the system of these net assets. Values may differ depending upon how the subsystems are diced and sliced in a sale.
5. Appraisals of exit values are both to expensive to obtain for each accounting report date and are highly subjective and subject to enormous variations of opinion. The U.S. Savings and Loan scandals of the 1980s demonstrated how reliance upon appraisals is an invitation for massive frauds. Experiments by some, mostly real estate companies, to use exit value-based accounting died on the vine, including well-known attempts decades ago by TRC, Rouse, and Days Inn.
6. Exit values are affected by how something is sold. If quick cash is needed, the best price may only be half of what the price can be by waiting for the right time and the right buyer.
7. Financial securities that for one reason or another are deemed as to be "held-to-maturity" items may cause misleading increases and decreases in reported values that will never be realized. A good example is the market value of a fixed-rate bond that may go up and down with interest rates but will always pay its face value at maturity no matter what happens to interest rates.
8. Exit value markets are often thin and inefficient markets.
Instead of criticizing exit value
accounting, what I would like to do is mainly criticize stock option accounting
under the present FAS 123 standard.
However, in the Appendix A to this letter, I will also criticize stock
option accounting under the exit value model proposed by Walter Schuetze.
Actually, the Financial Accounting
Standards Board (FASB) fought long and hard for a tougher standard that
required booking of stock options.
Ultimately, power centers from industry and the U.S. Congress forced the
FASB to weaken FAS 123. So here is what
is wrong with the present accounting rule.
1.
Asymmetry
How can employees receive something of great value from a company that reports
that no value has been sacrificed?
Employees are willing to take reduced cash earnings in order to receive vested
options. My best example is a recent
2.
Inconsistency
Under FAS 133 and 138, most other types of options must be booked and
maintained at fair value. For example,
if Company Tech uses market options to hedge profit on a short sale of $100
million of inventory not yet on hand, the purchased options must be booked and
adjusted at least every 90 days. Suppose
that the options lock in a profit of at least $25 million.
Company Tech could have instead locked in a profit by building the inventory
such that the short sale is covered. If
employee stock options were used to compensate employees building the
inventory, the employee options probably won’t be booked whereas the market
options must be booked. Even though
market options or employee options can be used for the same purpose to lock in
the profit, the hedge accounting differs like night versus day if the hedges
are from employee s options rather than market-purchased options.
Cash labor expenses of employees building inventories are booked as inventory
assets and expensed when those inventories are sold. Failure to book stock option value that
employees accept in lieu of cash wages can lead to tremendous distortions in
financial statements. Inconsistencies
between comparisons of otherwise similar firms arise if one firm (Company Cash)
pays all cash wages versus the other firm (Company Option) that pays minimal
cash wages and makes up the difference in stock options. I illustrate this in the Appendix A to this
letter.
Identical inventory may end up being booked in Company Cash for millions of
dollars more than in Company Option. For
example, Company Cash might book its DVD player for $100 per unit, and Company
Option might book its DVD player for $50 even though the DVD players are
virtually identical in features.
Differences in the financial statements between these two companies
arise from the inconsistent way cash wages versus option wages are booked.
Suppose this example is taken to an extreme where an
3.
Misleading Asset, Earnings, and Equity Balances
(Especially Cash)
Suppose Company Cash and Company Option also sell warranty services on
products. Solid companies like Company
Cash will usually pay cash salaries and wages to employees who actually perform
the work under the warranty contracts.
Cash-deficient firms (such as dot.com and other technology companies)
typically will induce employees to work for minimal cash wages and accept stock
options to save on cash outflow at the time.
Assume Company Option is such a cash-deficient firm. When employee stock options are not booked,
it is possible to construct scenarios in which Company Option has vastly
superior-looking financial statements than Company Cash even though the
stockholders in Company Option are really in far worse shape. Once again I refer you to the Appendix A of
this letter.
4.
FAS 123 May Render It Impossible to Compare
Investment Alternatives
Under
FAS 123, companies have a choice as to whether to book employee stock options
or not to book employee stock options.
For example, Boeing is a huge company with lots of employee stock options
that are booked and expensed when the options vest. Although this is exemplary accounting in my
viewpoint, Boeing takes a hit with lower reported earnings per share and ROI
when investors compare Boeing with the majority of other companies worldwide
that do not book and expense stock options when they vest.
5.
Organization Costs and Outside Service Costs
If
a company issues stock to outside accountants and lawyers for services in
forming a corporation, the company is required to estimate the value of those
services and debit the value as an asset called Organization Costs and Credit
Common Stock and Paid-in Capital. If the
company instead issues stock options to outsiders in lieu of common stock, the
option value must be is booked with the debit going to Organization Costs and a
credit going to Options. The main
difference in the accounting is that FAS 133 requires that the Options account
must subsequently be carried at fair value whereas actual stock is not adjusted
for fair value subsequent to the transaction date.
If a company issues stock to inside (employee) accountants and lawyers for
services, the company is required to estimate the value of those services and
debit the value as an asset called Organization Costs and Credit Common Stock
and Paid-in Capital. However, if options
are given instead of actual shares of stock, the accounting differs greatly
depending upon whether the recipients are outsiders versus employees. Employee stock options do not have to be
booked, whereas outsider stock options must be booked at estimated values.
The same inconsistency applies to services purchased with options subsequent to
a firm’s initial organization. If option
must be valued for accounting purposes for expensing of outside services, why
is this not the case for inside services?
I would contend that the main reason
companies, especially cash-deficient companies, fought so hard when the
Financial Accounting Standards Board (FASB) proposed booking of stock options
has nothing to do with accounting theory.
It has everything to do with dressing up the income statements and
balance sheets.
In an Appendix A to this paper, I will
provide a rather extreme illustration of why companies, especially
Very truly yours,
Bob
Robert E. Jensen
APPENDIX: A
The Nobel Cash Versus Nobel OptionCase
After earning a Nobel Prize in
Each company had only one highly skilled employee. The Nobel Cash employee agreed to cash wages, whereas Nobel the Nobel Option employee received an option to purchase 15,000 shares of stock. At the end of five years, she was entitled to exercise her option by paying out $10 for a share of stock having a par value of $1 per share. Actual value of the option depended upon the performance of her company and its outlook for the future that is extrapolated, in part, from past performance.
Both companies earned $2 for every $1 spent and had exactly the same revenue performance. To simplify the illustration, it will be assumed that no return was possible on any idle cash.
Accounting outcomes are shown in the ledger accounts below:
|
Accounting
Under Both FASB and |
Schuetze and
FASB’s FAS 123 Accounting |
Schuetze and
FASB’s FAS 123 Accounting |
|
|
Cash at the beginning
of Year 1 |
$10,000 |
$10,000 |
|
|
|
Nobel Cash |
Nobel Option |
|
|
|
Nobel Cash |
Nobel Option |
|
|
|
Nobel Cash |
Nobel Option |
|
|
|
Nobel Cash |
Nobel Option |
|
|
|
Nobel Cash |
Nobel Option |
|
|
|
Nobel Cash |
Nobel Option |
|
|
Year 5 Liquidation
Distribution of Cash |
Nobel Cash |
Nobel Option |
|
|
Cash Flow Summary
for Life of Company |
Nobel Cash |
Nobel Option |
|
Note that the Nobel Cash and Nobel Option accounting outcomes illustrated above would be generated out of either the current FASB rules or the exit value model proposed by Walter Schuetze. Both models are identical for a company that has only cash as an asset and no liabilities.
Over the five year period, the reported performance of the Nobel Option company was much better than the other company with earnings per share reported twice as high every year on the exactly the same revenue as the other company. After five years of operations, Nobel Option had a cash balance of $630,000 compared with only $320,000 for the company that had to pay higher cash wages every year.
If both companies had gone public with an IPO, chances are high that the Nobel Option company would have been much more successful in terms of the prices received for each share sold to the public. But when the companies liquidated after five years, the original shareholder, Kent Nobel, actually obtained less ($312,000) from the Nobel Option company than the $320,000 he received from Nobel Cash. He also lost voting control of the Nobel Option company while retaining control of the Nobel Cash company.
The above table illustrates why
If the companies did not liquidate after five years, the value to employees could be much higher than the $468,000 liquidation value. One major reason is the fact that intangibles are not booked, and the revenue growth suggests that there are some unbooked intangibles allowing the companies to double reported revenue every year. Value could also be less for a variety of reasons, including off-balance sheet financing and diminished optimism for future performance that is not yet reflected in the financial statements.
My bottom line conclusion is that failing to book (expense) employee stock options, in traditional or exit value accounting models, creates highly misleading financial reports that inflate earnings per share, retained earnings, and even cash and other assets. It is also possible to use the cash saved in wages to reduce debt, further improving the attractiveness of the a company that has, in effect, hidden “debt” in deferred employee compensation locked up on stock option plans.
Walter Schuetze argues that employee stock options are shareholder liabilities rather than the liabilities of the firm. I agree that employee option holders are not creditors, but they are out there silently gobbling up larger and larger shares of equity in their companies. The FASB fought long and hard for a tougher standard than FAS 123, but accounting firms like Arthur Andersen fought vigorously to derail the FASB’s attempts to require firms to book stock options when they vest. Under either current FASB 123 or exit value accounting, investors are misled by stock option accounting that does not book and expense such options when they vest.
My summary for how the Arthur Andersen fought against the FASB is summarized in the following reference:
Bob Jensen's Commentary on the Above Messages From the
CEO of Andersen
http://www.trinity.edu/rjensen/fraud.htm#Blame
(The
Most Difficult Message That I Have Perhaps Ever Written!)
APPENDIX: B
Exit Value Accounting With a Software Account
Disclosure Is
Not a Substitute for Recognition
APPENDIX: C
The Sad State of Tax Accounting for ESOs
APPENDIX:D
The Disagreement Between President Bush and Alan Greenspan Regarding Accounting
for ESOs
From The Wall Street Journal Accounting Educators' Review on April 13, 2002