Perspectives

February 2004

The High-Tech Community Must Surrender on Accounting for Options

By Robert I. Schwimmer

The aftermath of the technology bubble has taught business many lessons. In the accounting realm, one stands out: No longer should public companies be allowed to incur massive annual costs in highly dilutive stock option grants to executives ($3.3 billion and $2.6 billion last year for Microsoft and Cisco, respectively) without an appropriate charge to earnings that makes these costs fully transparent to shareholders and the equity markets, as well as properly reflect true personnel costs.

It seems intuitive that grants of extraordinary quantities of stock options played some contributing role in the decisions of managers to “cook the books” in varying degrees, ranging from aggressive accounting to blatant fraud. Clearly, the failure of financial accounting standards to require that the fair value of these option grants be booked as an expense in the year of grant helped enable certain brands of corporate malfeasance. If recent decisions by large companies like Coca-Cola to expense the fair value of its option grants mark the start of a bandwagon, then it is time for the high-tech community to get on board. So far, however, the high-tech community has balked, regardless of the damage to America’s confidence in its financial markets. Worse, resistance to this inevitable accounting change may invite greater acts of legislative “reform,” including an assault on the favored tax treatment of stock options.

Why Stock Option Compensation Is Good

The essential rationale behind the tax treatment of compensatory stock options is compelling. Under present U.S. tax laws, the grant of a stock option is not a taxable event for the employee. This was, and remains, very sound tax policy and should not be changed. Because there is no cash cost to the employer, companies that otherwise could not compete for the “best and the brightest” are nonetheless able to offer packages of below-market cash compensation bundled with tax-free grants of stock options. Nowhere is the usefulness of this tax policy more conspicuous than in the area of high-risk start-ups, early-stage companies, and other private, emerging companies.

Having represented some 50 early-stage companies since 1980 (of which only about 15% have been successful), the author can state unequivocally that for many, if not most, of these companies, the only chance they had of affording and attracting highly qualified, well-paid executives was to induce them to accept significant salary cuts, sometimes 50% or more, in exchange for the lure of hefty equity stakes. The alignment between ownership and management was accomplished because the recruited executive had, in the words of the venture capital community, “put skin in the game” by taking the pay cut, deferring their reward until investors are similarly rewarded (which is also when the executive would pay taxes).

The recruitment of seasoned executives enabled by noncash, no-up-front-tax-cost, compensatory equity arrangements radically improves the chances these companies will survive and thrive. While this arrangement costs the U.S. Treasury little, even with the low success rate of start-ups, the economy derives extraordinary innovation, increases in productivity, and job formation. But how can these cash-strapped companies be compared to the likes of Microsoft, Cisco, etc.? Are their executives really receiving equity quid pro quo for accepting reduced salaries, especially the highest-ranking executives? Are these companies seeking only the tax advantages that start-ups get, or are they also seeking financial accounting advantages?

The Failure of Financial Accounting for Compensatory Stock Options

To understand the issue, one needs to understand the difference between the “intrinsic value” of a stock option and its “fair value.” Compare two hypothetical Cisco Systems call stock options trading on the Chicago Board of Options Exchange (CBOE) at a time when Cisco shares are trading at $15; both are exercisable through December, but one has a “strike” (or exercise) price of $12.50, and the other has a strike price of $15.00. The $12.50 Cisco call option has an intrinsic value of $2.50, while the $15.00 Cisco call option has no intrinsic value.

The fair values are much different: the $12.50 Cisco call option is trading at $3.60, not its intrinsic value of $2.50, and the $15.00 Cisco call option is trading for approximately $1.25, not its intrinsic value of $0. Why? Because that “option privilege”—a time value of the privilege, as well as other factors, like volatility, interest rates—has a discreetly separate time-value, which is largely (though not entirely) independent of the intrinsic value of the options.

The current financial accounting rules applicable to grants of compensatory stock options are set forth in Accounting Principles Board Opinion 25, issued in 1972. APBO 25 provides that: The charge to a company’s earnings for an option grant is the amount of its “intrinsic” value, not its “fair value”—in other words, the time value of the option is ignored. And measurement of that intrinsic value is made on the date of grant if the number of shares and the exercise price are fixed at that time and the only risk of forfeiture for the employee is early termination of employment. This means that if the terms of the option grant satisfy those conditions and the trading price of the underlying shares on the grant date equals or exceeds the exercise price, there is no intrinsic value, and there is no charge to earnings.

In other words, if Cisco shares are trading at $15, and it grants an executive an option to purchase 100,000 shares for a price of $15 per share, forfeitable only if his employment is terminated (there’s usually a vesting schedule), what a CBOE trader would pay for those options (given the customary 5-to-10-year lives of these options, the price would be significant) is irrelevant: Cisco takes no charge against its earnings.

With the advent of exchanges like the CBOE and sophisticated option valuation models (e.g., Black-Scholes), accountants finally recognized that it was no longer “impracticable” to determine the fair value of options, and in 1993, FASB took steps to change the rules, only to back down under intense Congressional pressure: in October 1995, it issued SFAS 123, which merely encouraged companies to expense the fair value of compensatory options when granted, while permitting them to continue to follow APBO 25 so long as they included a note in their financial statements identifying the pro forma impact those costs would have had on earnings if SFAS 123 had been followed.

Given the ability to issue options without having to reduce their net income, companies had a new currency to pay executives. The late 1980s saw a new compensation phenomenon: extraordinarily large option grants. These grants were so large that an executive’s potential financial reward was now overwhelmingly weighted on how his employer’s stock performed in the stock market, regardless of how well the executive performed his job. One might have thought that corporate boards would have anticipated that such overweighted compensation might inspire aggressive accounting decisions by management. After all, boards have always understood that bonus arrangements influence management’s near-term decisions, and therefore are circumspect in their designation of achievement benchmarks to reduce self-serving executive behavior and encourage acting in the long-term best interests of the company.

So, why did corporate boards fail to appreciate that risk and overweight option-based equity as the primary compensation vehicle for senior executives? Four factors are to blame:

It Is Time for the High-Tech Community’s Opposition to End

The high-tech community has its arguments for maintaining the current rules. This author is skeptical of its recruitment and alignment arguments and rejects its assertion that because options aren’t a cash expense, create no liability, and impact only the equity side of the balance sheet, they should not be treated as the personnel costs that they really are. The high-tech community also says that SFAS 123 would necessitate quarterly recalculations due to fluctuations in stock price, overlooking the fact that there are many accounting calculations with “moving parts” and reasonable assumptions that have to be made and explained in notes to the financial statements (e.g., how energy companies calculate the value of their reserves).

But in an era that sanctified “consistent and reliable quarter-over-quarter earnings growth” and that saw first-tier technology companies able to produce earnings within a penny of analysts’ projections quarter after quarter, it defies common sense to imagine that executives have been thinking only of the value of their equity in their financial accounting decisions. After all, missing a quarter could result in reputation-killing firings, acquisition currency could be devalued, or depressed share prices could make the company takeover bait. Responsibility for the fouling of reputable accounting cannot be laid at the door of stock options alone. Nonetheless, with the unrelenting drumbeat of weekly financial scandals surrounding the overstatement of revenues or the understatement of expenses by major American corporations, it is obvious that American financial accounting standards will have to become more conservative if confidence in our financial markets is to be restored. Changing the financial accounting rules to require the expensing of stock options in the year of grant should be an obvious first step.

If this is not reason enough for the high-tech community to give up its position on option accounting, it should consider that the potential legislation which Congress may enact in response to the current crisis of confidence in America’s financial markets. Stock option accounting could suffer a fate far worse than cost-expensing on the date of grant. Embracing the inevitable change to current expensing of the cost of stock options would help avoid an even less desirable outcome.


Robert I. Schwimmer is a shareholder in the Chicago office of the national law firm Jenkens & Gilchrist, P.C.
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