— The Indepundit: Stock Options Revisited isn’t done with options yet, hauling out big guns Greenspan and Buffett (Warren, not Jimmy) on behalf of expensing them. Buffett says:
1) If options aren’t a form of compensation, what are they?
2) If compensation isn’t an expense, what is it?
3) And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?
So let’s answer Buffett, who was kind enough to take a break from buying the wired infrastructure of the Internet (while the world goes wireless) to help us out with this weighty question. Options aren’t a form of compensation, they’re an investment. People forego compensation for options, in many cases by making a direct choice, as I did on my last job where I was offered either a higher salary and an option for a certain number of shares, or a lower salary and an option for more shares. By choosing a compensation package that combines cash and options, we invest in the company. Companies don’t have to account on their balance sheets for the profits and losses shareholders make buying and selling shares, so why should they account for options?
One reason: the company has granted options for more shares than it holds in reserve to satisfy options. In this case, the company has to buy shares on the market when options are exercised. So this sort of a transaction certainly is an expense, and it probably should be reported.
But what if the company has sufficient shares in reserve to satisfy outstanding options? Should the paper value of these shares be reported as an asset, or as income to the corporation? We don’t know if options against such shares will ever be exercised, esp. if the options are underwater for some period of time.
So the question of how to account for options and how to account for shares held in reserve is a bit complicated, and until the proponents of expensing options can say how they want it handled, we don’t have much of a debate — it’s like every other issue in politics, where the parties generally agree on abstract principles, such as justice and freedom, but disagree on how to put such principles into action. We wouldn’t be having this debate, however, if the government hadn’t already passed a salary cap law. Options are a work-around for that law, and a messy one at best.
Evil communist Ted Barlow also weighs in on options, but no link to a particualr post since he’s a Blogspotter and his archive is hosed like all the rest of them. (p. s. – anyone who doesn’t like stock options is a an Evil Communist, by definition.)
I don’t want to get bogged down in details, so I’ve reduced my argument to two basic points:
1) I like stock options. I think they enhance productivity, and provide employees with a sense of ownership. In the past, I have accepted stock options as a form of compensation. So I guess I’m not really an Evil Communist, huh?
2) I don’t like the way corporations account for them. In response to your counter-argument that it’s difficult to assign a value to an option, I am going to do the cowardly thing and run for cover again behind big ol’ Warren Buffett, who knows a lot more about this than I do:
“I’ve bought and sold options for 40 years and know their pricing to be highly sophisticated. It’s far more problematic to calculate the useful life of machinery, a difficulty that makes the annual depreciation charge merely a guess. No one, however, argues that this imprecision does away with a company’s need to record depreciation expense. Likewise, pension expense in corporate America is calculated under wildly varying assumptions, and CPAs regularly allow whatever assumption management picks.”
Or, you can take Alan Greenspan’s idea:
“A stock option is a unilateral grant of value from existing shareholders to an employee. It is a transfer through the corporation of part of the market capitalization owned by existing shareholders. The grant is made to acquire the services of the employee, and presumably has a value equivalent to the cash or other compensation that would have been required to obtain those services–what economists call the ‘opportunity cost’ of employing those services. That value is obviously a function of when, and under what conditions, the option can be exercised. To assess the cash equivalent of the option, only the market value of the option at the time of the grant matters. Subsequent changes in the value of the option are not relevant to the exchange of labor services for value received, just as future changes in the purchasing power of cash received for services rendered do not affect the firm’s compensation costs.”
So take your pick. I really don’t care so much, as long as there is a reasonable standard that all investors understand, and can easily compare between different companies. I don’t think we have that today, and that’s not good for our economy.
Now, if anyone proposes legislation that bans the granting of stock options as a form of compensation, I’ll be right there beside you in labeling them as “Evil Communists.” But on the subject of expensing options, I think we’re just going to have to agree to disagree.
Apparently you’ve abandoned the position that expensing options would restore investor faith in the market, since both of these schemes are so extremely arbitrary as to amount to invitations for more bean-counter manipulation.
But Richard, you’ve just said that you’re taking the options in lieu of compensation. I don’t get to tell Uncle Sam or investors “My life insurance isn’t compensation — it’s insurance.” If I’m taking it in lieu of compensation, then it’s compensation. The fact that you’re gambling on the company may make it necessary to alter the value of the options you’re willing to take in lieu of a certain amount of salary, but there’s no reason to say it isn’t compensation. Nor does it mean anything to say “the company doesn’t pay for the options — the shareholders do” as a lot of proponents are fond of doing. The shareholders pay for everything — a dollar you pay an employee is a dollar the shareholders don’t get.
No one’s arguing that options should be made illegal; simply that the tax deferral and accounting treatment which make them especially desireable to companies in lieu of cash or stock grants should be altered, because outside of a startup environment, options start producing some very funny behavior in executives, but boards are wedded to them because of their tax and accounting favorability. Personally, I’d like to see stock grants take on the tax deferral attributes (and then get taxed as ordinary income) of options, and the ridiculous caps on executive cash compensation get lifted, but I’d also like to see options take on the accounting attributes of grants. The current setup is clearly distortionary.
Yeah — What Megan said.
The current setup is distortionary to the extent that companies use grants to top execs to circumvent the salary cap, I’ll give you that.
I don’t have a problem, in principle, with companies reporting options granted and exercised, and I don’t have a problem with expensing real, actual expenses related to stock options, such as any costs that arise out of the company’s need to purchase shares on the market to cover exercises, if that happens. I do have a problem with the invention of some arbitrary formula to value stock options granted out of a reserve that the company sets aside for that purpose when it’s founded.
The unions are strongly opposed to stock options in principle, because they blur the distinction between management and labor that’s so critical to creating an ongoing attitude of class conflict. They, and their Democratic Party stooges, want accounting for stock options to be so burdensome that companies stop offering them to the rank and file, and that’s the ultimate danger that has to be avoided in any accounting regulations that get adopted on this subject.