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CMA Management


Are stock options good business options?

CMA Management

Hamilton

May 2003

Eva Kupiec

Volume: 77

Issue: 3

Start Page: 13-14

ISSN: 12075183

Copyright Society of Management Accountants of Canada May 2003

When considering whether to use them or not, consider all the angles

Stock options are being picked on as a particularly suspicious instrument on the heels of recent financial turmoil. Critics see stock options as a reason for inflated data and dysfunctional managerial behaviour that's perceived as plaguing the business world. Some have entirely discredited stock options on the grounds that they fail to provide appropriate motivation to employees and erode profits in an almost undetectable way. Many scholars and policy advisors advocate that a full charge to earnings be taken for all employee stock options issued. Lately however, sporadic voices have defended the value of stock options as a compensation tool.

The use of stock options to reward executives and employees increased steadily in North America in the late '90s. According to Financial Markets Centre's survey of Fortune 200 companies, shares allocated for stock incentive plans more than doubled in the 1990s, amounting to 13% of all outstanding shares at the end of the decade. Business Week estimates that the value of stock options exercised by employees of S&P 500 companies reached $100 billion in the year 2000. The practice reached rank and file employees, not just executives. Watson Wyatt also reports that 19% of all employees were eligible for options in 1999, compared to 12% in 1998. Although often associated with the new economy sector, stock options are granted by companies in various industries, including the automotive, entertainment, and telecommunications industries. GM and Kodak use stock options as extensively as Microsoft and Cisco.

Many critics claim that stock options are a perfect way to transfer wealth from shareholders to executives. This is based on the principle that shareholders make capital contributions to an enterprise and the enterprise awards equity instruments to its employees through stock option plans. Others maintain that, just as investors pay their money into the business, employees bring in their talents and hard work, and therefore deserve a share in stock appreciation. Clearly, a balanced assessment of stock options' merits and pitfalls is necessary to reconcile these conflicting arguments and to increase our understanding of employee stock option plans as a business practice.

Equity or compensation?

The fundamental accounting question surrounding stock options is whether they should be treated as equity instruments and therefore have no impact on the income statement, or if they should be accounted for as compensation costs charged against profits in periods when incurred.

When stock options are awarded to employees at fair market value (which is a predominant practice), companies incur no out-of-pocket expense, other than some administrative fees. The subsequent transaction when options are exercised is settled with equity instruments, rather than cash. This is the basis for the belief that stock options don't affect a company's earnings, but merely its equity balance.

However, companies often launch stock repurchase plans to mitigate dilution and satisfy their stock option plan obligations. For example, in 2000, HP repurchased almost 97 million of its common shares for the aggregate price of $5.6 billion. Microsoft repurchased 89 million of its shares worth $6.1 billion in 2001 and 128 million of shares tor $6.1 billion again in 2002. Unfortunately, the proceeds from the sale of shares under stock option plans and increased cash flow from tax benefits on stock options will normally buy fewer common shares on the open market than those issued under stock option contracts. Companies, therefore, need to finance stock repurchases from other sources, using cash or increasing debt. This creates true costs associated with the use of stock options not properly reflected in financial statements previously.

Questionable numbers, real benefits

Dilution of earnings per share is another common reason why stock options have been attacked. Companies are required by FASB regulations to disclose the estimated value of stock option plans and their proforma impact on profits, so notes to financial statements report significantly reduced earnings per shares due to the stock option effect.

Studying notes to financial reports doesn't, however, guarantee that stock options' full impact on earnings will be deciphered. The Black-Scholes estimation model, used by most companies to assign value to their stock option plans, was originally developed for commercial derivatives traded on the open market. It generally assigns a higher value to options issued at a higher price, which isn't reflective of the employee stock options value. It's also based on many assumptions, such as the rate of return on a given security. These limitations account for the poor confidence in numbers presented in notes to financial statements.

In addition, companies face opportunity costs when releasing their treasury shares to award key officers' and employees' stock options (a prevalent practice). While achieving certain compensatory and motivational goals, companies forego some of the cash inflows associated with the sale of shares on the open market, as employee stock options are normally exercised below market price. The opportunity cost increases when stock appreciation is high, which is often the case for companies that use stock options heavily.

Stock options, however, do offer important benefits to companies. By tying a greater share of compensation to performance, companies shield their profits in times when sales deteriorate or costs rise. Stock options give companies greater liquidity, which is especially important in times of economic strain. Not surprisingly, stock options prevail in two kinds of corporations: those in early stages of operations favour stock options as cash is often in short supply; and those in highly volatile businesses see stock options as a way to mitigate labour costs, especially if their employees are highly skilled and need to be competitively compensated. Even if stock options were accounted for as true labour compensation, companies realize an immediate increase in cash flow (compared to traditional salary-based compensation models) because there's no immediate out-of-pocket expense associated with stock options.

Option planning

Some studies suggest that stock options, in general, may not be as expensive as they seem. A behavioural study by Steven Huddart and Mark Lang revealed that employees often exercise their options soon after vesting to minimize risk associated with stock price fluctuations. By choosing to exercise early, however, employees forego some of the assumed appreciation calculated according to the option valuation models. As a result, stock options cost the issuing company less then expected, and mitigate the opportunity costs, at least to some extent. According to this theory, then, the status quo isn't bad.

Professor William Sahlman of Harvard Business School, while acknowledging the merits of stock options in attracting good managerial talent to build long-term value for companies, asks whether "adequate controls exist to defeat malfeasance and damaging self-interested behaviour." In his own study of the subject, he rises above the quick accounting fix to stock option scandals (a full charge to earnings) and urges companies to examine the overall health of their compensation packages. He shows that if Enron and Microsoft recorded compensation charges for their stock options, Enron's income would fall by 10%, while that of Microsoft's would lose a whopping 30%. So a careful sensitivity analysis should be undertaken by companies to determine what level of risk associated with stock options provides motivation to employees rather than incentives to unethical, dysfunctional behaviour.

National interests

The increasingly extensive use of stock options has at least two major economic implications as well. Firstly, it affects government tax receipts. Secondly, transactions associated with stock options affect the system of national accounts and related economic performance indicators.

Even though treated as labour compensation costs, stock options are not taxed as employment income, but as capital gain. Deferral of a portion of stock option benefits until the exercise date accounts for further delays in imposing tax on these employment-related benefits. This is favourable for the awarded employees, but not for fiscal policy or for those concerned with timely collection of taxes and the redistribution of national funds.

As exercised stock options make up n part of labour compensation in our national accounts, they reflect fluctuations associated with the specific market conditions conducive to exercising vested options. Such fluctuations don't, however, reflect a trend in labour cost behaviour that can be explained by labour market conditions, but instead point to specific stock market trends that influence the behaviour of stock option holders. Such trends may be unsustainable or erratic, as they depend on the number of exercisable options during any given quarter, psychological factors affecting employees owning the options, and general stock market moods. Since labour compensation cost is considered an important economic indicator of inflation, it's important to understand what portion of labour cost is attributable to the exercise of stock options in any reporting period.

Complex and controversial, stock options are an important part of our business reality today. As the reporting regime for options changes, it's important to remain sensitive to their intricate nature. Employee stock option plans should be aligned to specific business environments and subjected to sound business controls.

[Sidebar]

The use of stock options to reward executives and employees increased steadily in North America in the late '90s By trying a greater share of compensation to performance, companies shield their profits in times when sales deteriorate or costs rise

[Author note] Eva Kupiec, CMA, (geminiconsulting@sympatico.ca) is a Toronto-based consultant.


Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
huddart@psu.edu
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