OK, accountants, I’m puzzled by something I see proposed in the new laws for business reporting. Basically, they’re saying options should be listed as expenses.
So - how do you value an option? If my company gives me 1000 options at $35, the value of the options is nothing until (and if) I exercise them. If I use them while the stock sells at $40, that’s $5000 dollars, if I exercise them when the stock is $36, they’re worth $1000. If hold onto them because the stock never goes over the option price and they expire, they’re worth precisely $0.
So how is a company expected/required to value these for expense purposes? I’m genuinely puzzled.
I am no accountant but I thought the expense was to be tallied only for exercised options. So when you cash out, that’s the charge. I am sure someone will set me straight.
They are, in effect, selling you an asset well below market value. They would expense the difference between what you paid for them vs. what they would have received in open trading.
Are you sure about that? I don’t understand how that would make sense. It seems like it would be a huge expense on paper–one that often is never even realized at the bank.
It’s like a variation of the thing my old man used to say, “if I had a nickle for every option I never got to exercise, I’d be a rich man.”
Well, I’m not too well versed on the technicalities, but there’s certainly some way to estimate the worth of options. They do it for tax returns every year, after all.
If it was impossible to do, Greenspan wouldn’t be calling for it.
But in that case you could only expense them when the option is exercised, because only at that time is there any actual value (the delta between the market price of the stock and your exercised cost for the stock.) That’s often 10 years after it’s been given to the employee.
And they are talking about expensing these up front - for example, a lot of start-up companies are in a tizzy about this, because they often offer options in lieu of larger salaries, and they’re being told they have to expense these up front. Their argument is that they’re being forced to claim an expense that may never be real, due to the tenuous nature of the value of value (and future existence) of a start-up.
Again, I am puzzled as to how true value can be assessed before the actual exercise of the option, years after its issue.
A suggestion I saw that makes sense is valuing the options at the price they would get on the open market. Companies can, and do, sell options on their stock to investors; so the argument is that here they’re effectively “selling” the option to the employee, and then giving the money they used to purchase it right back to them.
I’m sorry, I meant that’s how it should be done, not how it would be done.
Example:
ABC Inc gives CEO Joe an option to buy 1,000 corporate-owned shares at $10/share. 3 years later, CEO Joe exercises this option and gives ABC, Inc $10,000. Currently, ABC Inc stock sells on the NYSE for $100/share. ABC Inc just sold $100,000 of corporate-owned assets for $10,000. In effect, the company gave away $90,000. This should be marked down as an expense.
Part of it, in short, is that if options are expensed, when they expire, unused (as every option I’ve ever been granted has been) they have to be treated as a revenue. This could open up all kinds of new ways to play with income statements, and make company books even more complicated and inpenetrable.
ABC Inc just sold $100,000 of corporate-owned assets for $10,000. In effect, the company gave away $90,000. This should be marked down as an expense.
Yep, that’s what I originally thought. That options would only be marked as an expense after they were exercised. This way you have a value.
But after looking around a bit, I think I had that wrong. Jeff explains it in his post. The idea is to account for options when they are issued, not when they are ultimately called in.
Accountants calculate values for things whose values are unmeasurable all the time. They have no trouble assigning value to loans that might not be collected, office buildings whose prices rise and fall with the real estate market and interest rates, and all kinds of contracts whose final value will not be known for years.
Calculating the value of options, in fact, is one of the great accomplishments of modern business mathematicians, Blitzer said. “There is very little in financial modeling that has been tested more than options pricing models. There have been a zillion PhD theses written on it.”
Now that I think about it, how does this even stop the abuse? Just because there is an expense on the front end, how does that keep an unethical CEO from inflating the value of the company for a short term gain?
So then the expense would be whatever your strike price is?[/quote]
It’d be whatever the market price is at the issue for the options themselves, not the shares, since options are the “right to buy at a given price.”
Hmm, see if I can explain this: an option is a right to buy an asset at a contractually specified price anytime during the lifetime of the option, regardless of the actual price of the asset. Basically, if you buy an option for four years on say, 1,000 shares of MSFT stock at $45/share, then for the next four years you can pay $45 a share for up to 1,000 shares, and they’ll give you the shares regardless of how much they had to pay for them.
You’re making an investment decision that at some point in the lifetime of the option, you’ll be able to exercise the option (buying the shares for the strike price), immediately sell the shares, and come out with more money than you paid for the option up front. Options function like any other market, so the price you pay for it is whatever the interaction of supply and demand set the price at.
It’s actually a lot clearer in gambling terms: the option value is whatever you paid to make the bet. You have to pay that regardless of whether it pays off or not.
Now, on to employee stock options: employees get the option for free, so you can effectively treat an employee stock option as compensation to the employee equal to the value that given option would receive on the open market.
An equivalent way to specify what the company loses in an employee option grant is that the company loses, at the time they give the option they grant to the employee, the cash they could have sold it for to a non-employee. Using the gambling analogy, it’s like the company giving the employee some free chips (ignoring the “keep them in the casino” aspect of free chips, which doesn’t apply here); it’s all downside for the company.
Ah - thanks Jason. I completely forgot that options can be purchased on the open market and thus have a “real” value at the time of issuance, which has nothing really to do with the actual exercised value (which is the “real” value in my mind.) I was purely thinking of employee options given as a benefit and their actual realized value.
Hmmm. Still seems pretty amorphous, and I’m still not convinced it had much to do with the actual criminal dishonesty going on in a few companies.
I see what your saying now. Thanks for explaining that to me. It’s funny that I hear so much about options and I’ve discussed it with people at length, but still get confused. Accepting a job where compensation includes lots of options but a low salary really is a huge gamble–no wonder those unethical CEOs are the only one’s who can make it work!
In an indirect way, options, and especially not expensing options, encourage “irregularities.” Not expensing options encourages their use more than if they were properly expensed, and the problem with using options in the first place, instead of other forms of compensation for employees, is that they have a pretty bad case of moral hazard.
On the evidence so far, who is right? One place to look for the answer is bosses’ pay. The theory is that the huge amounts of stock options dished out to executives in the 1990s encouraged them to behave badly. Unlike stock itself, a stock option has no downside: the owner might gain a lot of money if his company’s share price rises, but he loses only the cost of the option if the share price falls (and nothing at all if the option is given to him). That might have encouraged excessive risk-taking at the top—a willingness, as Ira Kay of Watson Wyatt, a pay consultancy, puts it, to “roll the dice”.
Combined with the freedom to sell the company’s stock once the option is exercised, stock options might also have encouraged short-term business strategies, or even fraud. By fiddling with their accounts, company bosses could hope to drive up the share price, cash in their options, and set sail in their yachts.
I’ve seen an argument that Congress made some sort of “cap” on direct CEO salary in the 1986 tax law at 1 million by not letting any amounts above that be deductable from taxes, but I can’t find anything about it online. Anyone know about this? If that’s the case, it should definitely be removed, as that in of itself will drive the use of options instead of salary above 1 million.
I don’t have a solution for how to compensate a CEO without encouraging unethical behaviour, but I can tell that there is a downside to options that the author of the economist story leaves out: loss of potential compensation. The deal with most companies that offer huge grants as part of compensation is that you have to endure a low salary. I read somewhere that maybe the solution is just to give actual stock instead of options. I could get behind that. I can’t think of a downside for CEOs or mere mortals.
“Hmmm. Still seems pretty amorphous, and I’m still not convinced it had much to do with the actual criminal dishonesty going on in a few companies.”
Maybe not, but if handing out excessive options to high level execs makes it harder for the company to look profitable, I’m all for it. These guys come in with the idea of doing whatever it takes to drive up the stock price, and I think they tend to cut corners and, sometimes, abuse employess by cutting jobs to look more profitiable in the short run. Handing out a lot of options should put some downward pressure on the price of the stock.
I’ve seen an argument that Congress made some sort of “cap” on direct CEO salary in the 1986 tax law at 1 million by not letting any amounts above that be deductable from taxes, but I can’t find anything about it online. Anyone know about this? If that’s the case, it should definitely be removed, as that in of itself will drive the use of options instead of salary above 1 million.
I believe the $1 million “cap” was passed as part of Clinton’s first tax package in 1993. It is a sham because it includes language about no more than $1 million “unless” based on specific goal achievement or some such language. The compensation experts have long left any problems associated with that rule behind. CEOs get plenty of salary and cash bonus before any stock options kick in. The stock options are what drives the salaries into the tens or hundreds of millions of dollars in annual compensation.
1986 tax law
I almost lost my dinner that someone thought that Ronald Reagan and a Republican Senate would approve a piece of tax legislation that actually capped executive compensation.
You’re right, it was 1993. I can’t remember if it was part of the Clinton tax plan or not. Looks like the capped deductability of golden parachutes back into 1984, though.
Pat Buchanan was in favor of it, though. I keep forgetting exactly how much of a literal (heavy control over business is a common thread) fascist he is.
