September

What Controversy?

I have several comments and concerns about the May article, “Accounting for Stock Options: The Controversy Continues” (Nicholas G. Apostolou and D. Larry Crumbley):

Editor’s Note: The writer is immediate past chair of the NYSSCPA SEC Practice Committee.


 

The Authors Respond:

We certainly appreciate Robert Waxman’s detailed response to our article. However, we did not write the “In Brief”: the errors in that section of the article are editorial in nature.

In terms of the article itself, Waxman is only partially correct about the deductibility of stock options (e.g., stealth compensation). A company may claim a deduction for incentive stock options (ISO) if they become “messed-up ISOs.” Stock options may start out as ISOs, but one of the conditions may not be satisfied (i.e., holding periods). For a messed-up ISO, a company should be able to take a deduction in the same year that the employee recognizes ordinary income on the spread at the sale date.

Although we do not have the data, we suspect that nonqualified stock options (NQSO) are more common than ISOs because NQSOs provide more tax advantages for companies than ISOs. For example, according to the New York Times (June 20, 2001, p. C1, 8), stock option tax benefits made up 67% of operating cash flow at Sun Microsystems, 41% at Cisco Systems, 34% at Yahoo, and 30% at Juniper Networks.

Waxman is correct in pointing out the slip under “Background” as to the allocation of stock option expense. As the article mentions, compensation expense is recognized over the vesting period—the time between the grant date and the vesting date.

Mr. Waxman’s doubt about the continuing nature of the controversy over not expensing stock options is easily refuted. A Fortune cover story titled “The amazing stock option sleight of hand” (June 25, 2001) discusses the very same issue. The article concludes that “No amount of accounting magic can change this fact: Options aren’t free”. The article includes two tables that illustrate the effect of expensing stock options on earnings per share: one for “old economy” stocks and another for “new economy” stocks. As the table in our article also indicates, the potential dilution from expensing stock options is much more pronounced for new economy stocks than for old economy stocks. In addition, extensive coverage of stock options was presented on June 4, 2001, in the Wall Street Journal (p. C1, C17), and the New York Times on June 20, 2001 (p. C1, C8). The New York Times article makes the same point we make and bears repeating: “because the cost of stock option grants are not considered a wage expense, the earnings at companies giving out large option grants looked better than the results at companies that paid cash to workers.”

Finally, readers should judge the continuing importance of the controversy by the performance of the stocks in our table. The stocks of companies whose earnings would have been most affected by expensing stock options plunged far more in the recent stock market debacle than stocks of companies that relied less on options as a form of compensation.

Nicholas G. Apostolou, PhD, CPA
D. Larry Crumbley, PhD, CPA

Louisiana State University, Baton Rouge



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