ARTICLE

The Daily Recorder -- May 17, 2004

Corporations And Capital

Expensing Options Is Bad Math

The Financial Accounting Standards Board (“FASB”) has, as has long been expected, come out in favor of having accountants treat the granting of stock options as a corporate expense.

Competing with FASB on the policy front are technology companies and others who support the pending Baker-Eshoo (HR 3574) Stock Option Accounting Reform Act. Under the Reform Act, Congress would tell the accounting standard-setters that options cannot as an expense, except in the case of senior company executives (a compromise approach aimed at addressing Enron-style abuses without destroying the value of companies of having option plans that cover a broad group of company employees).

The policy argument against option expensing is that companies will grant fewer options once they represent a charge to the bottom line. The losers, when fewer options are granted, are companies who can’t recruit talent because they don’t have cash, and employees who are willing to accept the wealth-building potential of options as a component of pay.

Beyond policy, though, option expensing is bad math. Notwithstanding that the accounting industry, which is very good at math, is promoting the option expensing, the math proceeds from a flawed premise.

Investors experience dilution from options. That is, a 10 percent owner owns less than 10 percent of the company once options are exercised. Expense is an unrelated measurement. Option expense is a reduction of earnings, based on an estimated value of the option.

Moreover, the expense measurement is not meaningful to any real user of financial statements.

There are four users of financial statements:


1. The company itself, to measure performance and operational needs.
A financial non-cash expense for stock options, like non-cash expense for depreciation or goodwill amortization, does not provide operating information. It may provide some competitive or tax information, but not operational data.
2. Lenders, to measure assets and cash flow capabilities to service debt.
Options don’t affect lenders directly.
Options could affect market perception of the debtor company, or motivate a debtor company to adopt stock repurchase programs, which would affect free cash flow that might otherwise be used to repay debt. There is no direct impact on lenders from the mere issuance or exercise of employee options.
3. Investors.
Investors are directly affected by dilution when options are exercised. Dilution, however, is not expense. Investors are also affected if a company uses free cash flow to repurchase shares to reduce dilution, but such repurchases, when they take place, are already reflected in financial statements.
4. Tax authorities.
The government needs to know if the company made or lost money, in order to assess tax. Options are already separately handled under the Internal Revenue Code, and their treatment in financial statements is not considered.

The explanation offered by those favoring option expensing boils down to “if employees are willing to take options in compensation, then options are an expense.” But the argument is false, because options are “paid” in company stock, not cash (in fact, the employee pays the company to buy the stock).

There are various methods developed by the accounting industry to make theoretically sound estimates of the “cost” of options. But just because accountants CAN make an estimate does not mean that they SHOULD make an estimate.

Simultaneously reducing earnings (by expensing) and increasing dilution (through option exercises) results in a double counting of the impact of stock options on a company, to the detriment of investors.

Bruce Dravis is a partner at Downey Brand LLP, operating primarily in the firm’s Sacramento and Roseville offices, specializing in corporate, securities and business law. His column appears in The Daily Journal on the third Monday of each month. Any political comments are his own and not those of Downey Brand LLP.